Technicians are taught that volume will reveal the intention of price. In other words, we're trained to believe that short-term buying and selling pressure predicts longer-term price direction, intensity and timing, at least when it's interpreted correctly. But there's a problem with volume in our modern diabolical markets -- it doesn't tell the truth anymore.

OK, that's an exaggeration to some extent. There are still trading scenarios in which raw volume data and carefully analyzed accumulation-distribution indicators are vital to accurate price prediction. However, these are exceptions to the rule in this brave new world, in which an overreliance on the bottom half of the chart can get you into a lot of trouble.

Yes, you heard me correctly. Traders should just ignore volume patterns most of the time because it gets in the way of making money. This is a relatively new market phenomenon. Zoom back to 2000 or 2005 and you'll find that volume activity exhibited most of the predictive characteristics laid out in the classic technical analysis books.

But times have changed, with modern computer systems overwhelming the natural forces of supply and demand. Add the skyrocketing number of total transactions generated by orders being subdivided into micro units and it's become nearly impossible to make sense of the order flow of a typical market day, week or months.

Consider the three volume sources that are corrupting your nightly investigation of the stock market:

1. Pension and mutual funds, moving slowly and covering their tracks within the broad noise of daily market movement.

2. High-frequency trading algorithms, generating profits through minor fluctuations in the bid-ask spread.

3. Massive trading in index derivatives and exchange-traded funds that generate lockstep adjustments throughout the component shares.

Indeed, volume has become a crazy quilt of misdirection since lightning-fast computers and emotionless algorithms took over the market landscape. We have two choices in dealing with this unpleasant turn of events. First, we can sit back and hope for a return to "the good old days." Second, and a better choice, we can limit our volume analysis to extreme events and price-volume correlations at major highs and lows.

News shocks can generate transaction levels falling so far outside the norm that we can't ignore the influence on price direction. Even then volume data can be misleading. A perfect example arises when a stock gets added to the S&P 500 index. The news generates enormous volume, as index funds scramble to purchase shares. But buying in-sync with the funds, a great strategy just five years ago, no longer guarantees a profit because the stock's rise instantly triggers a barrage of predatory algorithmic responses.

So when do you bite the bullet and actually believe the volume data you're staring at? Not surprisingly the most favorable scenario is a high-volume breakout or breakdown. Look for a minimum of 3 to 5 times the 60-day moving average of volume to print for that instrument and for price to thrust away from support or resistance in a wide-range bar.

This scenario works most reliably on speculative stocks that are popular with the retail and momentum crowd. These issues usually aren't components in broad index funds, so can they avoid the overriding influence of algorithmic basket strategies that force entire sectors to move in lockstep. In addition, it's easier to align high-volume activity to events, milestones, and developments specific to that company.

Jazz Pharmaceuticals (JAZZ) -- Daily
chart
Source: eSignal

Jazz Pharmaceuticals ( JAZZ) shows that volume interpretation still works on the right instruments, when properly applied. The junior biotech broke out of an eight-month base in June, posting heavy volume after positive Phase 3 trials for its primary drug application. Volume then eased off in a gentle slope for over a month, indicative of systematic profit-taking and zoomed higher in increased volume earlier this week, confirming the initial rally and signaling a technical breakout.

When price and volume work together, as they do on the Jazz pattern, chances are good the emerging trend will yield to substantially higher prices or lower prices. Volume data also works with the classic on-balance volume (OBV) indicator when signals are unambiguous and price sits at a key level, testing a major high/low or a moving average.

Geron Corp. (GERN) -- Daily
chart
Source: eSignal

The best volume data, as illustrated in this Geron ( GERN) chart, comes with a strong OBV breakout while the stock remains stuck under a major resistance level. This is a bullish divergence predicting that price will surge in an attempt to "catch up" with the rising indicator. In the alternative, OBV lagging rising price is a bearish divergence at these testing points, with an expectation that any breakout attempt will fail.

To sum up, classic technical analysis teaches that price and volume are interconnected by a hidden spring that allows one side to stretch away from the other, until a friction point is reached and the other side plays catch up. However, this relationship has become unreliable, and even dangerously inaccurate, in recent years.

For this reason, most traders should just focus their undivided attention on the price bars, and avoid the confusion that volume brings to the analysis.


Alan Farley provides daily stock picks and commentary with his "Daily Swing Trade" newsletter.

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

Alan Farley is a private trader and publisher of Hard Right Edge, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. 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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