Volume Rate of Change
An old market axiom says that volume precedes price.
The trading volume of a stock, i.e., the number of shares traded in the stock in a given period of time, like a day, is considered by many traders to be the fuel that drives the stock. It is seen as an important indicator of the projected trend of the stock. Increasing volume trend portends higher prices ahead; in this sense, volume precedes price.
But volume is interpreted differently in different situations. According to Bauer and Dahlquist, for example:
... when a new high for a stock is accompanied by heavy volume of trading, the market is considered to be bullish. On the other hand, when a new high is associated with light volume, analysts assume that, because there is not much fueling the rally, the increase in price may be a temporary move.
When a new low occurs with light volume, the light volume indicates low investor participation in the stock price drop. This type of drop is not viewed as significant. However, when a new low occurs with heavy volume, many investors are trading at this lower price. The increased volume is seen as fuel for a downward trend in the market and extremely bearish.
High volume has other potential implications, though. This is the situation where the volume is deemed to be climactic. At these times -- at the end of a bullish upsurge, for instance -- there is panic short-covering by traders who believe market prices are going even higher, and wildly so. They want to get out as fast as they can and in their rush create panic buying.
And at the end of a bearish trend, holders of stock finally throw in the towel, believing that prices are gonna drop out of sight. So they dump their stocks, finally willing to take any bid they can get, thus creating panic selling.
Many technicians claim price moves and volume characteristics are closely related. A trading system based on this idea assumes that, in the words of Bauer and Dahlquist, "increases in volume indicate support for the market." Consequently, an increase in the price of a stock that's accompanied by an increase in volume shows that traders are supporting the market price. Also interpreted as climbing the wall of worry.
Similarly, when the price decreases, and you get a corresponding increase in the volume, this shows that trader support of the market is decreasing. Increasing volume thus supports a trend and decreasing volume fails to support the trend. Also seen as the slippery slope of hope.
Volume Trend System
A volume trend system is formulated by defining the average volume move over some period of time. As with other such systems, you have to select a look-back period over which to take the average. Next you have to choose the percentage change in volume that you consider necessary to detect a volume trend. Then, finally, you need to choose a delay period to be able to say how many days the trend has to be in effect before a signal is generated. The choices are yours to make.
Bauer and Dahlquist give as an example the case where a five-day delay is incorporated. So, if the (average) volume increases for five days in a row and is accompanied by rising prices, an upward trend is detected. This is bullish and signals a buy. On the other hand, if the volume increases for five days but is accompanied by falling prices, this detects a downward trend, which is bearish.
This reading of volume is like the Chaikin Level Divergence discussed here and is based on work by Joseph Granville and Larry Williams. You look for clues in the changing volume to decide. One clue is suddenly increased buying or selling of a stock relative to prior trading periods. This shows a changing attitude by traders toward the stock.
To build the trading system you have to choose a number of trading periods as a basis. Then, for each day, you calculate the volume accumulation. This is done by using the following formula:
VAcc.i = Volumei(((Closei - Lowi) - (Highi - Closei))/(Highi - Lowi))
Notice that the accumulated volume for the day can be negative. This occurs if the closing price for the day is near the low. In that case the day's action reduces the overall accumulation, which means you're getting some distribution. If in fact the close is the low, the percentage distribution for the day is high.
Now you have to add up the daily accumulations over the trading basis, which we can say is P trading periods, or P trading days. The total accumulation over the P days is then:
VAccT = å VAcc.i, for i = 1 to P.
The total volume for the P days is:
VT = å Vi, for i = 1 to P.
And the volume accumulation percent is:
VAccTP = 100(VAccT/ VT)
If price falls while the volume accumulation percentage is rising, a long signal is generated to benefit from the expected price reversal. Conversely, if price rises while the percentage decreases, a sell signal is generated.