Turn Down the Volume

Price and volume are the flesh and blood of technical analysis. Throughout our education we're taught that volume reveals the intention of price. In other words, we're supposed to believe that trading flow predicts price direction when it's interpreted correctly. But I have a major problem with volume, because it doesn't tell the truth anymore.

I'm exaggerating to some extent. There are specific situations in which volume data is vital to accurate price prediction. But I believe these are exceptions to the rule, because volume interpretation gets you into a lot of trouble these days.

Yes, that's correct: Traders should ignore volume most of the time, because it gets in the way of making money. This is a relatively new market phenomenon. Just a few years ago, volume exhibited all of the characteristics ascribed to it in the TA books. But times have changed, and derivative instruments have now corrupted the predictive powers of volume data.

A big chunk of volume these days has nothing to do with supply and demand. Instead, heavy trading in index derivatives generates continuous adjustments to the component shares. This in turn spawns volume bars that say nothing about price direction. Add in the related influence of basket trading, and volume becomes a crazy quilt of misdirection.

A secondary malevolent force undermines volume-based data. The explosion of direct-access scalping ensures that a large chunk of volume is driven by pure noise. After all, that's the basis for successful scalping techniques. Scalpers play the spread and use the equity's random movement to book small profits. Once again, the end result is a pile of worthless volume bars.

To deal with this minefield, limit your volume investigation to extreme events. These are prints that fall so far outside the norm that their influence cannot be ignored. Even then, volume data can still be misleading. A perfect example is when a stock gets added to the S&P 500 index. The announcement generates enormous volume as index funds scramble to purchase shares.

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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. At time of publication, Farley had no positions in equities mentioned in this column. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback and invites you to send it to [e-mail]. 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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