Get an Edge With Volume Indicators

01/13/06 - 12:02 PM EST

AMTD GS (Action Alerts PLUS PICK) LEH NLY

One of the tricky things about writing for RealMoney is that the readership changes over time. As such, I can't get away with making a quick reference to a technical concept, because a lot of people may have missed my explanation of it in an earlier column.

On Wednesday, I said that Celgene (CELG - Cramer's Take - Stockpickr) was not at a good buy point. I circled a "price by volume" bar on the chart and noted that a lot of buyers were waiting at the $58-$62 level. Not surprisingly, I received several emails asking me to expand on this.

The charting source I use includes an indicator known as "price by volume," or PBV. It serves largely the same function as "volume-weighted average price," or VWAP, which comes with more expensive programs. The indicator measures trading volume at various levels. For example, if trading volume at the $40 level far exceeds the trading volume at $47, then the "price by volume" bar at $40 will be much longer than the bar at $47. More volume, longer bar.

Why does this matter? One of the most useful aspects of technical analysis is its ability to determine where the most financial (and hence, emotional) commitment lies. Knowing where most people sold their stock gives you an edge. If the stock subsequently rallied after much of it was sold, there will be a lot of latent demand at that price -- the sellers feel regret that they didn't hang on. They'll rectify that mistake if they get a second chance. So if the stock starts falling back to the level where all those "sold-out bulls" lie, their demand is very likely to halt the pullback at that level. We'll look at this concept using the charts of several broker dealers, but let's first understand two things:

A high degree of activity at a particular level does not mean that this level must be tested. Rather, it simply illustrates the location of demand -- demand that may never be met because the stock continues to move higher.

PBV is very useful in setting stops. Very often, people complain that their stop will be hit just as demand is kicking in. That's known as selling at the bottom -- often done, but never happily. Using PBV, set the stop a bit below the level of latent demand. That way, if demand is satisfied but selling pressure persists, you'll cut your losses before the stock declines to the next level of support -- which may be far lower.

So let's look at PBV in the charts below.

The XBD index does not have a volume measurement, so there are no PBV bars here. However, we can see the continual assault on $200 that finally broke through last week. While the index looks overextended, note that it has advanced just 3% this month. Nice rally, but not to such an extent that the broker/dealer stocks are ripe for a fall.

Ameritrade (AMTD - Cramer's Take - Stockpickr) is in a prolonged uptrend. The stock continues to track the upper Bollinger band -- the statistical top end of the trading range. I've placed blue circles on the PBV bars at significant price levels. Note the very short PBV bar at the $24 level. With such light trading volume, there just aren't that many people who sold the stock and are now waiting for a chance to buy it back. However, notice the longer PBV bar at the $19 level. If the stock falls that low, the odds increase that the latent buying demand will halt any pullback. The extremely long PBV bars at the $11-$12 range dramatically increase the likelihood that any decline will stop at this level.

Remember that there is a seller for every buyer. All those people who sold at $11 or $12 are kicking themselves. A pullback to this level gives them the second chance they are waiting for.

Assuming you are long Goldman Sachs (GS - Cramer's Take - Stockpickr), where do you put your stop? Put it at $129 and you'll likely get stopped out on any pullback. That's where the PBV bar is a bit longer than most, and the odds favor a bounce. Why stop yourself out right in the area where a bounce is most likely?

Instead, place it lower -- in the mid-$120s. The stop will get triggered only if demand wanes. (Note that I am only focusing on the location of the stop relative to the PBV bars. The location of the stop relative to your entry is something entirely different.)

Lehman Brothers (LEH - Cramer's Take - Stockpickr) is just popping out of a volatility squeeze. By definition, a volatility squeeze marks the breakout from a tight sideways trading range. Given all the churning at the squeeze level, the PBV bar will be long. This heavy volume reveals the existence of a lot of unhappy sellers who sold too soon. If the stock pulls back to test the breakout, they'll probably snap up the stock. Compare the $127 level with the $120 level. The PBV bar at $120 is extremely short. As such, any decline to $120 is unlikely to find significant buying interest. Nobody cares.

Lastly, let's look at Annaly Mortgage Management(NLY - Cramer's Take - Stockpickr). It's not a broker dealer, but it has a darn good chart.

This double-bottom looks pretty bullish to me. Yesterday's decline was on such light volume that the uptrend is probably just resting, not ending. But the longest PBV is below $12 -- right around $11.50. Determining stop placement here is really tough. Set it too tight and you risk losing your position to a sold-out bull. From the current position, I really can't see a logical stop location higher than $10.93 (the most recent low). Any higher level could result in a sale just before a triple bottom is formed. So what's the solution here? Scaled entry. Don't take it all at once, because you just might want to buy more if the stock pulls in.

Be careful out there.