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Chapter 5 Volume Analysis For Stocks

Importance of Volume in Technical Analysis

“Price is the king but volume is the key”. Volumes lead prices. If prices start moving up on high volumes, there is a very good chance that this rise will be sustained. However, it is very important to understand where the volumes have occurred and where the price movement has taken place along with the volumes.

Price Volume Effect
Rising Price Rising Volume Strongly bullish momentum
Rising Price Falling Volume Unreliable or even bearish
Falling Price Rising Volume Strongly bearish momentum
Falling Price Falling Volume Unreliable or even bullish

Though the above is true and applicable in normal situations, there are some exceptions. For instance, at extreme points, i.e. at times when prices have moved up sharply, and at lows when the prices have fallen sharply, this logic may not work.

Volume Analysis on Stocks

Volume is the one of the most important parameters used in Technical Analysis. Volume provides information of how many shares changed hands and at what price in a stock over a given time frame, giving an indication of interest in the stock.

Since each stock is different, and has a different number of outstanding shares, volume should always be compared to the historical volume of the stock in consideration to spot changes in volume trend. Volume is also used to confirm price trends, breakouts, and spot potential reversals.

Using Volume to Analyze Stock Price Movements

Monitoring volume simultaneously can aid in analyzing stock price movements. There are three primary ways volume is made use of in conjunction with price analysis: Confirming Trends, Spotting Potential Price Reversals, and Confirming Price Breakouts.

Confirming Trends

Increasing volume shows conviction of buyers and sellers in either pushing the price up or down respectively. For example, if the trend is up and volume increases as the price moves higher, it shows buying interest and this is typically associated with larger moves to the upside going forward.

In the above chart, State Bank of India represents the above mentioned analysis as the volume gradually increases as the price surges higher. If you have taken a bullish position, the rising volume helps to confirm the uptrend. If you are short, the rising volume on the price rise tells you the price could continue to trend higher and it may be time to exit your short position.

A trend can persist on declining volume for long periods of time, but typically declining volume with a rise in prices indicates that the trend is weakening. For example, if the trend is up but the volumes are steadily declining, it shows that there are only few traders who are driving the stock leading to a rise in price without broader participation. Any larger selling pressure could lead to a reversal in the uptrend leading to a sharp correction in the stock.

Volume should ideally be larger when the price is moving in the trending direction, and lower when moving against the trend (pullbacks). This shows the movement in the trend direction is strong and the pullbacks are weak, making the trend more likely to continue.

Spotting Price Reversal

For a trader to spot price reversal, identifying exhaustion move is important. Exhaustion move can be defined as a scenario wherein a particular stock moves higher with lower volumes and reaches its peak of its extended rally with maximum volumes i.e. 5x-10x of its average daily volume. This could possibly indicate the end of current trend.

Example 1: In the chart above of Repco Home Finance, we can observe a classic example of an exhaustion move, price hits an all time high with a huge spike in volumes, buyers get exhausted and with few buyers left to push the price higher, we see a reversal in the trend of the stock in the following days.

Example 2: In the chart below of Bharat Petroleum, we witness a sharp decline in price along with a significant rise in volumes as the stock price hits its multi-week low, indicating an exhaustion of sellers as majority of the ones who wanted to exit have exited this stock. And with few sellers left to push the prices downwards, buyers took the upper hand stock leading to recovery in prices.

Confirming price breakouts

In a scenario, a particular stock has strong Support or Resistance levels, volumes can help to confirm a breakout. If the price has struggled to get above a certain resistance point, a conviction of buyers can be witnessed if the breakout is supported with larger volumes. Such breakout is likely to be legitimate.

In the above example of CESC Ltd, we witness a breakout from the sideways consolidation pattern on the daily chart backed by a steep surge in volumes. As the volumes increased with price breaching above Resistance level, a possible bullish breakout can be expected.

A break above Resistance, or below Support, on lower volumes shows little conviction of the trade leading to the failure of the breakout. A common problem in Technical Analysis is buying an upside breakout, or selling a downside breakout, when volume doesn’t confirm it.

The chart above of Titan represents a false breakout. Assume that you had bought near the top of this range at Rs 542 expecting the price to move to Rs 560 levels, which is the target derived from a rectangle chart pattern breakout with a stop loss of Rs 525. In such a case, your bullish trade would have resulted into a huge loss as the stop loss price of Rs 525 got triggered since the breakout was not backed by strong volumes which provided a false signal, leading to a drop in price.

Confirming price pattern breakout

Price pattern breakout is similar to price breakout depending on volumes for confirmation.

In the above example of Ashok Leyland, we witness a cup and handle breakout backed by a rise in volumes which give an added confirmation to the trader. The stock has managed to hit its target price of Rs 110 which is derived from the cup and handle formation.

Key Takeaways

  • Volume is used as a secondary indicator.

  • Volume gives an indication of interest in a stock.

  • Volume is also used to confirm price trends, breakouts, and spot potential reversals.

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