Why is Volume Important?
Volume analysis is the technique of assessing the health of a trend, based on volume activity. Volume is one of the oldest day trading indicators in the market. I would dare to say the volume indicator is the most popular indicator used by market technicians as well. Trading platforms may not have a particular indicator; however, I have yet to find a platform that does not have volume.
In addition to technicians, market fundamentalist also take notice to the number of shares traded for a given security.
Bottom line, the volume indicator is one of the simplest methods for observing the buying and selling activity of a stock at key levels. The tricky part is volume can provide conflicting messages for the same setup. Your ability to assess what the volume is telling you in conjunction with price action can be a deciding factor for your ability to turn a profit in the market.
In this article, we will cover how to assess the volume indicator to help us determine the market's intentions across four common setups:
- Trending Stocks
- Volume Spikes
- False Breakouts
Strategy 1 - Breakouts and Volume
Traders will often look for breaks of support and resistance to enter positions. For those fans of the Tradingsim blog, you know that I exclusively trade breakouts in the morning of each session. There are two key components to confirm a breakout: (1) price and (2) volume. When stocks break critical levels without volume, you should consider the breakout suspect and prime for a reversal off the highs/lows.
The below chart is of Netflix on a 5-minute time interval. You will notice that Netflix was up ~15% throughout the day after a significant gap up. Can you tell me what happened to Netflix after the breakout of the early 2015 swing high?
The interesting thing about the Netflix chart is that the stock never made a new high after the first 5-minute bar.
This is a prime example where a stock may have broken a high from a few weeks ago, but is unable to break the high for the current day. As day traders, you want to wait until the high of the day is broken with volume.
A key point for you is that every swing high does not need to exceed the previous swing high with more volume. I used to obsess over this and if I didn't see more volume I would walk away from the trade. Looking at the chart of Netflix above, do you honestly think the stock will exceed the first 5-minute bar with increased volume? Of course not!
While this charting example did not include a break of the daily high, when you look for stocks that are breaking highs, just look for heavy volume. Please don't beat yourself up because the 9:35 bar had 150,000 shares traded and the break of the high at 10:10 am only had 132,000.
Now if you see a break of a high with 50% or 70% less volume, this is another story. Again, if we are within the margins, please do not beat yourself up over a few thousand shares.
In a perfect world, the volume would expand on the breakout and allow you to eat most of the gains on the impulsive move higher. Below is an example of this scenario.
Let's test to see if you are picking up the concepts of breakouts with volume. Take a look at the below chart without scrolling too far and tell me if the stock will continue in the direction of the trend or reverse?
Come on, don't cheat!
The answer to my question - you have no idea if the stock will have a valid breakout. From the chart, you could see that the stock had nice down volume and only one green candle before the breakdown took place. This is where experience and money management come into play, because you have to take a chance on the trade.
You would have known you were in a winner once you saw the volume pickup on the breakdown as illustrated in the chart and the price action began to break down with ease.
For those that follow the blog, you know that I like to enter the position on a new daily high with increased volume. You will need to place your stops slightly below the high to ensure you are not caught in a trap. This strategy works for both long and short positions. The key again, is looking for the expansion in volume prior to entering the trade.
- The stock has volatile price action with the majority of the candle color mirroring the direction of the primary trend (i.e. red candles for a breakdown and green candles for a breakout).
- On the breakout volume should pickup
- The price action after the breakout should move swiftly in your favor
Strategy 2 - Trending Stocks and Volume
When a stock is moving higher in a stair-step approach, you will want to see volume increase on each successive high and decrease on each pullback. The underlying message is that there is more positive volume as the stock is moving higher, thus confirming the health of the trend.
This sort of confirmation in the volume activity is usually a result of a stock in an impulsive phase of a trend.
The volume increase in the direction of the primary trend is something you will generally see as stocks progress throughout the day. You will see the strong move into the 10 am time frame, a consolidation period and then acceleration from noon until the close.
For this strategy, you will want to wait for the trade to develop in the morning and look to take a position after 11 am. For those that follow the blog, you know that I do not trade in the afternoon; however, this doesn't mean you can't figure it out.
As the stock moves in your favor, you should continuously monitor the volume activity to see if the move is in jeopardy of reversing. The speed of this setup is much slower versus the other strategies discussed in this article; however, the difficulty reveals itself in the increased number of false moves, which are commonplace in the afternoon.
Think I'm kidding about false breakouts, let me show you a couple.
These charts are just a sample of what happens far too often when it comes to afternoon trading. So, how do you find the stocks that will trend all day? After many years of trading, I can tell you I honestly don't know.
- Look for volume to push the stock in the direction of the primary trend
- You need to be prepared to hold a stock for multiple hours in order to reap the real rewards
- Once you figure out how to identify the stocks that will trend all day prior to 10 am, please shoot me an email
- Instead of using volume to predict which stocks will trend, simply use volume as an indicator that keeps you in a winning position
Strategy 3 - Volume Spikes
Volume spikes are often the result of news driven events. It occurs when there is an increase of 500% or more in volume over the recent volume average. This volume spike will often lead to sharp reversals, since the moves are unsustainable due to the imbalance of supply and demand. Trading counter to volume spikes can be very profitable, but it requires enormous skill and mastery of volume analysis.
These volume spikes can also be an opportunity for you as a trader to take a counter move position. You really need to know what you are doing if you are going to trade volume spikes. The action is swift and you have to keep your stops tight, but if you time it right, you can capture some nice gains.
Let's walk through a few volume spike examples, which resulted in a reversal off the spike high or low.
In the below example we will cover the stock Zulily. The stock had a significant gap up from $13.20 to almost $16.
Notice how the stock never made a new high even though the volume and price action was present. This is a key sign that the bears are in control. For this setup, you will want to focus on the following key items:
- The high or low of the first candle is not breached
- The first candle has significant volume
- The subsequent heavy volume events further establish the reversal in trend from the initial spike at the open
- Place your stops directly above the high or low of the first candle
Volume Spikes with Long Wicks
The other setup with volume spikes are candlesticks with extremely long wicks. In this scenario, stocks will often times retest the low or high of the spike. As a trader, you can take a position in the direction of the primary trend, after the stock has had a nice retreat from the initial volume and price spike.
Below is an example from a 5-minute chart of the stock Depomed, ticker DEPO. You will notice how the stock had a significant gap down and then recovered nicely. Once the recovery began to flat line and the volume dried up, you will want to establish a short position.
Let's take another look at a long wick setup. The below chart is of Frontier Communications, ticker FTR with a long wick down. The stock then recovered and went flat, which was an excellent time to enter a short position.
- Identify a high volume gap with a long candlestick on the first bar
- Wait for the stock to eat into the morning gap and volume to drop off
- Take a position in the direction of the primary trend with a price target of the low or high of the wick
Strategy 4 - Trading the Failed Breakout
I would be remiss if I didn't touch on the topic of failed breakouts. As a day trader that specializes in early morning breakouts, I have my fair share of trades that just don't work out. So, how do you know when a trade is failing? Simple answer - you can see the warning signs in the volume.
Let's dig into the charts a bit.
Above is the chart of Amazon and you can see the stock attempted to breakout in the first hour of trading. Notice how the volume on the breakout attempt was less than stellar. As a trader, you shouldn't be surprised when the stock begins to float sideways with no real purpose. While this would have been a bad trade, because your money is idle, it's still much better than what I'm getting ready to show you next.
The above example of ESPR would drive me crazy 6 years ago. Notice how the volume dries up as the stock attempts to make a lower low on the day. The key for you as a trader to get out is the price action begins to chop sideways for a number of candles. When you sit in a stock hoping things will go your way, you could just make a donation to charity. At least the money will go to a worthy cause.
- Breakouts fail quite often
- If the volume dries up on the breakout, look to get out within a few candles if things don't turnaround
- If you want to play the reversal, wait a few candles to see if the peak holds and enter a trade counter to the morning gap
- You can use the peak of the first candlestick as a logical point to exit the trade
The strategies discussed in this article can be used with any stock and on any time frame. The most important point to remember is you want to see volume expand in the direction of your trade. Keep this in the back of your mind and you will do just fine.
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