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Volume is one of the simplest and most undervalued indicators around. Like indicators in general, volume alone does not give the whole picture. It doesn’t tell us which direction a market is trading in, and it can both prematurely lead and lag behind big moves, making it hard to connect increasing volume with trend strength or potential changes in trend.
The solution is to use volume with price movement and other indicators to fill in some of these missing pieces. If volume changes its behaviour when combined with a recognizable pattern, the market may well be tipping its hat.
An easy way to spot changes of behaviour in volume is to add a moving average (or even standard deviations) to volume. This provides a benchmark for highlighting volume extremes.
Extremes in volume – especially high volume days – often occur at the continuation of an existing trend or the beginning of a new one. High volume will often exhaust buyers or sellers, making way for reversals and strong moves.
The chart below shows a large volume spike on Consolidated Minerals Limited (CSM:ASX) on 17 August 2007. The larger the spike, the larger its significance. Spikes of more than 500% are often worth investigating, as are spikes that are larger than those of the previous 12 months.
Chart 1 – CSM Volume Spike
click chart for more detail
As discussed earlier, however, volume spikes alone can give false signals and be misinterpreted. To reduce the chances of this, four additional gauges can be considered.
One, you can see that CSM has bounced off its 200-day MA (green) twice recently, suggesting that a third bounce is possible.
Two, the chart is currently in a Wave 4 Buy with a reasonable price retracement and Oscillator pullback (Oscillator not shown).
Three, the volume spike bar itself has what is known as a doji in candle stick charting – a popular reversal signal that suggests indecision.
Last but not least, the low of the volume spike day has tagged the lower Bollinger Band without the bar closing outside it.
These additional gauges help confirm whether the volume spike is a valid signal to use as a reference point for trading.
Chart 2 – Wave 4 Volume Spike
click chart for more detail
To recap, one should compare volume spike to its average as well as other volume spikes in the last 12 months. Then add classic price and indicator reversal signals to help confirm what the volume is saying.
Combining these elements builds a far more solid case for a change in trend (or a confirmed Wave 4) than a volume spike alone.
Happy Trading
Jordan Craw
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