Leading Or Lagging?
Spike Up The Volume
by Giorgos Siligardos, Ph.D.
A long spike appearing in the volume histogram usually catches your attention. But how do these spikes in volume really affect indicators and prices?
Volume can be considered to be the fuel of the markets. When the daily trading volume of a security is extremely high compared to its average daily values, that means it's attracting a large number of buyers or sellers. Oftentimes, this huge rush leads traders awry.
In his article "A Tale Of Two Indicators," Andrew Tomlinson gave an interesting example of two volume indicators that diverge, giving opposite signals. The daily volume spike along with a gapping down hammer created these signals, and Tomlinson noted that this divergence was due to the nature of the formulas of these volume indicators. Here I will discuss the concept of volume and show that volume spikes actually do not provide signals that indicate which way prices will go, but rather provide instantaneous alert signals.
THE TWO-FACED BUS THEORY
One of the basic guidelines of classic technical analysis is that bullish periods need high volume to continue, whereas bearish periods could continue without the need of high volume. Moreover, when the volume starts to fall in a bull market, it suggests that a bearish market is near. An analogy from physics is a "two-faced" bus, like those airport buses with two driver's seats used to transfer passengers and personnel, moving up and down a hill. The bus represents the tradable, the height of where the bus is on the hill represents the price of the security, and the trading volume represents the fuel of the bus. When the fuel starts to diminish, the bus may stop advancing and fall back due to its weight and the laws of gravity. If the bus driver wants to go down the hill and has enough fuel, he or she may step on the gas pedal and the descending acceleration will be much stronger than the natural acceleration of the gravity. This simulates the idea that bear markets accompanied by high volume are extremely severe.
The two-faced bus theory also models consolidation periods with diminishing volume. This is when the bus runs out of fuel and needs to wait until its fuel tank is filled again. Only after the fuel tank is filled can the bus decide where it wants to go.
How are volume spikes represented in this model? By a sudden filling of the fuel tank. When this happens, the bus may travel a long way in the direction it wants. As soon as the fuel tank is suddenly filled, the will of the bus (if it had a will) - not unlike an 18-year-old boy with a brand-new car filled with gasoline - instantaneously becomes unpredictable (which may be the reason why many oscillator developers advise not to use oscillator signals accompanied with high volume). Let us explore this situation further using a common-sense approach.
...Continued in the June issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the June 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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