Volume Price Analysis; Part 1

Volume is often one of the most popular indicators in technical analysis and it can also be one of the most powerful if the data is utilised correctly. As well as being the most popular, it is one of the oldest forms of analysis that is utilised by market technicians when assessing the health of a trend and strength of a particular price movement. It can be used when trading all asset classes but is most frequently used in equities. Given its simplicity in observing the buy and sell activity of a stock at key levels it is also often overlooked as an indicator but in this author’s opinion is most helpful in predicting movement of price of a given asset.

Support and Resistance - Breakouts

When a particular stock is being monitored by a trader/analyst, they will often look for breaks of either support or resistance when starting positions. Some traders specialise in only trading breakouts and these key historical support and resistance points, when coupled with volume are fundamentally important when using this trading strategy. Traders will only trade on breaks of support or resistance as generally when these key levels are broken an asset has more room to run (in either a downward direction, i.e. in instances where support is broken or in an upward direction i.e. in instances where resistance is broken). Therefore simplistically speaking, when a stock has broken resistance, I would initiate a long position and when a stock has broken support, I would initiate a short position.  When these pivotal points of either support or resistance are broken, it is referred to as a breakout.

The more frequently that the stock has bounced off a particular price (the support) and been supported at that level by more frequent buyers, heavy buying activity (volume) then more significance should be paid to that historical support level. Conversely the more frequently that a stock has been unable to breach a particular price, bounced off of it (the resistance) and been with resistance by more frequent sellers, heavy selling activity (volume) then more significance should be paid to that historical resistance level.

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Using purely support and resistance levels a common investment strategy used by some traders would be to buy at support and sell at resistance just using historical charting, however in this channel of support and resistance you don’t always know which direction the price of the stock is going to go so buying in this area is what is commonly referred to as the ‘dead zone’. With reference to, and with an understanding of volume, this strategy of buying at support and selling at resistance can, however, prove fruitful for traders. For example if it is clear that a move downwards in price to test support is made with low selling volume then it is likely this support line (on whatever timeframe it is being tested in) will hold firm. Stocks will often then bounce off of support if buyers have been purchasing historically at this point. Remember volume can validate price and price can validate volume so for any moves down in price we must look for volume to confirm the validity/strength of the move. For a break below support or above resistance to occur, and then hold it must occur with volume otherwise this move would be considered as weak and a trader would then make a bet in the opposite direction of this move. In the below image, resistance was tested on three occasions and on the third time made the break above resistance. Prior to the breakout, we can see that there was strong and rising volume, until the point of breakout which validated the move with much larger than average volume. Large volume prior to break-out is often a good precursor to an upcoming breakout.

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Spotting a Breakout with volume

There are two key data inputs to confirm a breakout: The first is price and the second is volume. In an instance where a stock breaks critical support or resistance levels (N.b. it is also important to understand the historical strength of a specific support or resistance level when looking at the strength of a move) with low-volume, then that particular breakout would be considered weak and likely to fail. These moves are often referred to as fake-outs as a break above or at resistance on low volume would be primed for a reversal off the high reached. Likewise if a break below support was made with low volume then this would be considered as primed for a reversal upwards off the low reached. In a breakout the volume would be high and rising, the price action that followed this rising volume would always be in your favour (the opposite is true on a break down below support).

Anna Coulling’s book ‘A complete Guide to Volume Price Analysis’, a must read for any keen trader or investor for that matter, best describes the  principle behind breakouts by using the analogy of the support area being the floor and the resistance area being the ceiling. She explains that the ‘initial move higher up and through the ceiling level (resistance), has to be accompanied by strong and rising volume in order to break out from congestion…’ The same is true of any stock or asset that you chart, and you should see this strong and rising volume associated in the next few volume bars on any timeframe as the market pulls away. If you don’t see this then you will know the break out is false and that that at this timeframe there is no interest from market participants to take the market higher and in doing so setting a higher ceiling. If the move up is a valid one, the volumes on the initial break of resistance will be considerably above average and rising. Following this, most breakouts are preceded with low or falling volume as the market pulls back, since we are now developing a bullish trend higher and expect to see a rising market with rising volume, if the move is a true move higher. Traders often trade breakouts by defining congestion zones using pivots, then charting the price action using volume and price analysis and then enter positions when the volume has validated the move.  See figure below.

Image result for breakout from congestion strong and rising volume

Congestion is the phase when a stock is consolidating having previously broken through resistance or support. It is the zone whereby there has historically been support and/or resistance and is congested with buyers and sellers. The longer a stock has struggled in this congestion zone the more likely it is that the move upwards or downwards would be significant. Once a stock has broken through the areas of congestion, i.e.in the dead zone), it will break away and will eventually be met with a new point of resistance/ceiling. Therefore in order to spot an asset or particular stock with breakout potential there must be clear sky or a gap ahead, where there are no congestion zones. The more clear sky there is between the next congestion zone, the longer the stock will run for before new sellers enter the market and a new ceiling/area of resistance is made. To trade breakouts we must understand that the market is always testing and retesting these areas of support and resistance, so if we see low and falling volume on pullbacks this is a good sign. In this instance the market is testing seller interest, and decreasing seller interest is a good sign.  Once the sellers dry up in the market, the buyers will step in and the stock will rise as it breaks away.