How to Best Use Volume When Trading

Volume impacts trading decisions on many levels, from initial position choice through exit timing. But it's also the Achilles heel of technical analysis because there are so many wrong ways to interpret it. Let's clear up some of these misconceptions and find the best applications for this valuable tool.

To start, traders routinely misread the sequences of green and red volume histograms under price bars, reaching all sorts of inaccurate conclusions about market direction. In reality, true accumulation or distribution can remain hidden from public view for long periods through the application of judicious position building or dismantling.

This is the type of concealed activity that develops at major bottoms and tops. Value players use the exhaustion period after a sharp decline to build positions slowly at advantageous prices. At tops, professionals are taking profits quietly and setting new short positions into place to benefit from expected rollovers.

We see this process in action with Schering-Plough (SGP - commentary - Cramer's Take). The stock traded up to a five-year high in May on solid buying pressure. Clandestine sellers showed up more than two weeks before price peaked late in the month. It then took two more weeks for gravity to take control and drop price into a sustained correction.

Proper reading of accumulation/distribution has kept me out of more trouble over the years than any other market measurement tool. That's why I look at on-balance volume on all my daily charts, focusing on the relationships between price and indicator at or near significant highs or lows.

OBV leading price to new highs is bullish because it predicts the uptrend will accelerate in order to relieve the imbalance. These are the types of relationships you see when stocks ignite into parabolic rallies. Conversely, OBV lagging rising price is a bearish divergence that predicts a stalled or failed breakout, sometimes with dramatic results.

Parametric Technologies (PMTC - commentary - Cramer's Take) rallied to a six-month high in June, but OBV signaled a bearish divergence because it couldn't press above the peak of the late-2006 indicator high. In fact, the sharply declining indicator predicted the conflict might resolve itself violently. As it turns out, poor earnings triggered a nasty down gap, negating the breakout.

Climatic volume events take place in all time frames. These are emotionally charged periods when the herd surges in and established trends flame out. Classically we see these turning points after long-term rallies or selloffs on daily charts. But they're now showing up regularly in the intraday markets.

This is a consequence of our all-or-nothing electronic market culture. In an effort to reduce or eliminate market inefficiency, program algorithms search for the prices that attract the most traders. Markets are pushed into these levels, triggering volume thresholds that, in turn, cause the program to flip over and move in the opposite direction.

This is why so many equities seem to move two steps forward and 1.99 steps backward these days. A volume push in one direction sets a short-term trap that feeds on the buyers or sellers entering positions at those levels. This triggers a continuous oscillation that frustrates position traders, but delights daytraders and scalpers.

Warnaco Group (WRNC - commentary - Cramer's Take) is a current pick in The Daily Swing Trade. Back in early June, the stock gapped up to an all-time high at 37.40 in the fifth day of an upswing. Price hit an air pocket immediately, dropping almost two-points in the next 30 minutes. Look at the high volume triggered by that sudden nosedive.

The opening trap filled the pockets of short-sellers that morning at the expense of the public coming into the market and buying at the opening price. This is a classic blowoff scenario, even though it's taking place on a 15-minute chart. The event shut down the trend for the next three weeks, with the stock finally moving higher in late June.

Finally, lets talk about intraday volume, as displayed by bid and ask size on the market-depth screen. This real-time tool, better known as Level II, allegedly shows the quantity of stock being offered for purchase and sale at different price tiers. Many folks still believe these layers of interest show legitimate supply-and-demand data.

Nothing could be further from the truth. Simply stated, these numbers are totally fictitious and designed to fool public traders.

There are numerous ways to hide or manipulate the bid/ask size on the Level II screen. Consider iceberg orders as an example. The name really says it all. You can place a buy or sell transaction in which just a small percentage of the total order is shown to the public. The size is then refreshed continuously until the entire execution is completed.

Program algorithms also use bid/ask size to paint pretty pictures. Their complex logic can display thousands of shares across different market centers near current price, then lift them all in microseconds and reverse when volume hits an order threshold. That's why you'll see a single 100-share sale drop a market that's apparently stacked with liquidity.

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At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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