Introduction to the Stock Market_13. Volumes and Trends

Lesson 13: Volumes and Trends

#What is Volume?

Volume is the number of shares of stock, bonds, options, or futures contracts traded
over a designated period (e.g., daily, weekly, monthly). Advancing volume is the total
volume for all stocks increasing in price; declining volume is the total for all stocks
decreasing in price. To remove variability elements, it may be advisable to smooth
this measure with a moving average (e.g., 5 days).

Volume reflects the intensity (strength) of a stock, commodity or index. Volume also
provides an indication of the quality of a price trend and the liquidity of a security or
commodity.

#What volume reveals about the market's strength?

✓ High volume means greater reliance can be placed on the movement in price
than if there was low volume, because heavy volume is the relative consensus of
a large number of participants.

✓ High volume indicates an active market; in an active market, the spread between
bid and asked prices is usually narrower.

✓ High volume is often characteristic of the initial stage in a new trend, such as a
breakout in a trading range. Before a market bottom, investor nervousness
leads to panic selling, a characteristic of which is high volume.

✓ High volume is also attributable to a market top when strong buyer interest
exists.

✓ Low volume often exists during an unsettled period, such as at a market bottom.
Low volume reflects a lack of confidence that is usually indicative of a
consolidation period when prices are within a sideways trading range.

✓ A sizable increase in volume may point to a breakout (start) or climax
(culmination) of a move, which may be temporary or final. In a rare case, it may
represent a shakeout.

✓ Volume typically follows a trend, expanding on rallies and decreasing on
reactions. Volume is useful in ascertaining how strong a change in expectations
really is.

#How volume and price moves reveal the market’s trend?

It is important to look at the relationship between volume and price. A price move,
up or down, that is on higher volume is more significant. Therefore, an analysis of
price and volume allows the investor to better interpret the trends in price and any
changes thereto. In other words, volume gives an indication of the strength
(momentum) of a move in price.

Current trading volume and average trading volume should be compared. Average
trading volume typically decreases when a stock is in a downtrend, because
investors view negatively a stock declining in price. An increasing price is typically
coupled with increased volume, but the price can decrease without an increase in
volume if investors lose interest in the issue. On the other hand, a declining stock

price may be coupled with higher volume when, for example, negative news comes
out about the company.

The significance of a change in volume is related to the associated price trend or
pattern. For example, a good time to buy stock is when there are simultaneous price
and volume increases. The accompanying Table provides general rules for volume
analysis.

General Rules in Volume Analysis

Volume Price Interpretation
Increasing Rising Bullish
Decreasing Falling Bullish
Increasing Falling Bearish
Decreasing Rising Bearish

Volume should be evaluated in appraising market strength or weakness. If volume is
increasing, whether prices are going up or down, it is probable that prices will
continue their current trend. However, if volume is decreasing, the current trend will
probably not continue and a reversal may be imminent.

A strong uptrend usually has more volume on the upward legs; similarly, a strong
downtrend will have more volume on the downward legs. After the trend ends the
corrective leg usually has lower volume. A downtrend may nevertheless be extended
whether average trading volume increases, decreases, or is static.

Volume is relative in that it usually is greater approaching the top of a bull market
than near the bottom of a bear market. Further, trading volume typically increases
and continues higher than average in an uptrend but is below average during a
downtrend.

Trading volume typically goes up as the price breaks out to the upside of a pattern or
formation. In this case, a significant increase in volume is a strong buy signal.
However, volume is an indicator of a trend reversal if it goes in a direction contrary to
a prevailing trend.

Volume/price analysis, on balance volume, upside/downside volume ratio and line,
volume up days/volume down days, cumulative volume index, trade volume index,
positive volume index, and volume reversal are among the ways volume can be
analyzed.

#What is Trend?

The trend is the general direction of a market or of the price of a security. In technical
analysis, trends are identified by trend lines that connect a series of highs or lows.
Most traders trade in the same direction as a trend, while contrarians seek to identify
reversals. Trends can also apply to interest rates, bond yields, and other markets
where they're characterized by a long-term movement in price or volume.

Technical analysis was founded on the premise that security's prices trend over time,
which makes identifying the trend one of the most important elements of the practice.

Traders can identify the trend using various forms of technical analysis, including
both trend lines and technical indicators. For example, trend lines might show the
direction of a trend while the relative strength index (RSI) is designed to show the
strength of a trend at any given point in time. Many traders live by the mantra, "the
trend is your friend", with the exception of contrarians that seek to identify reversals.
Trends may also be used by investors focused on fundamental analysis, which looks
at changes in the revenue, earnings, or other business metrics. For example,
fundamental analysts may look for trends in earnings per share and revenue growth.
If earnings have grown for the past four quarters, this represents a positive trend.
However, if earnings have declined for the past four quarters, it represents a
negative trend.
Using Trend Lines
The most common way to identify trends is using trend lines, which connect a series
of highs or lows. Uptrends connect a series of higher lows, creating a key support
level for future price movements. Downtrends connect a series of lower highs,
creating a key resistance level for future price movements. In addition to support and
resistance, these trend lines show the overall direction of the trend.

The above example shows a bullish trend line along with an RSI reading that
suggests a strong trend. As the trend began to lose strength, with the falling RSI
reading, traders may have started to exit the stock. The breakdown from the bullish
uptrend represented a potential change in the longer-term direction of the trend.
Trend traders that were long in the security may have sold their shares and waited
for a better entry point, while contrarian traders may have looked to initiate a long
position after the stock had fallen and the RSI had bottomed out.
# Uptrend

An uptrend describes the price movement of a financial asset when the overall
direction is upward. In an uptrend, each successive peak and trough is higher than
the ones found earlier in the trend. In the example below, notice how each
successive high and low is located above the previous ones.

For example, the high at point 4 is above the high at point 2 and the low at point 5 is
above the low at point 3. The uptrend is broken if the next low on the chart falls
below point 5. The opposite of an uptrend in a downtrend.
An uptrend provides investors with an opportunity to profit from a security until it
reverses. Selling a security once it has failed to create a higher peak and trough is
one of the most effective ways to avoid large losses that can result from a change in
trend. Many technical traders also draw trendlines to identify an uptrend and spot
possible trend reversals.
Moving averages are another popular tool used to determine if a security is in an
uptrend. Traders look for price to be trading above the moving average and for it to
be rising. Measuring the strength of a trend can be achieved by using the average
directional index (ADX) indicator. Readings between 25 and 50 indicate a strong
uptrend is in place, while readings under 25 tell traders that a security is
rangebound. Investors who trade uptrends may be referred to as “trend followers” or
“momentum traders.” (For further reading, see: The Four Most Common Indicators
in Trend Trading.)

#Entering an Uptrend

The best time to enter an uptrend is when price retraces back to a support level.
Support can come from a trendline, a moving average or previous price action. For
example, a security might retrace back to its 50-day moving average, or a previous
swing high.
Traders can also use momentum indicators, such as the relative strength index (RSI)
and the stochastic oscillator, to help determine when an issue may be reaching an
oversold level. For instance, a trader may buy a stock if its price returns to an
uptrend line and the RSI is below 30. Good entry points in an uptrend should have a
confluence of support from multiple indicators.

In the example below, the retracement to a key support level proves to be an
excellent entry point. Support comes from the long-term trendline, the 50-day moving
average and an oversold stochastics reading:

#What is Downtrend?
Downtrend is the opposite of uptrend, it describes the price movement of a financial
asset when the overall direction is downward. A formal downtrend occurs when each
successive peak and trough is lower than the ones found earlier in the trend.
Notice how each successive peak and trough is lower than the previous one. For
example, the low at Point 3 is lower than the low at Point 1. The downtrend will be
deemed broken once the price closes above the high at Point 4.

Many traders seek to avoid downtrends because they can drastically affect the value
of any investment. A downtrend can last for minutes, days, weeks, months or even
years so identifying a downtrend early is very important. Once a downtrend has been
established (series of lower peaks) a trader should be very cautious about entering
into any new long positions.