Interpreting Volume Systematically

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Most systematic approaches to volume apply a long-term smoothing method to the data, then identify trend changes to confirm price direction. This can be implemented with any of the accumulation indices, but not with single-day momentum or oscillator values. For the oscillators, most analysts have taken the approach that high volume confirms a new price direction; therefore, they look for a reversal signal at the same time as peak or near-peak volume. If they do not occur at the same time, a volume peak should precede a trend change. A decline in volume has also been used to confirm direction, but it is more likely to indicate that prices have reached equilibrium, and that a further advance or decline requires additional confirmation.

Moving Average Approaches

A straightforward way of using volume is to calculate a 10-day moving average of the volume to be used as a confirmation of a 20-day trend position.4 By simply requiring the current volume to be greater than the average volume over that past 10 days, you introduce the idea of greater participation associated with the new trend. An additional important benefit is that this volume condition acts as a filter, eliminating a substantial number of trades. If the net returns are the same, the volume-filtered approach is far better because you are out of the market more, and are not reversing your position every time there is a new signal.

A similar method was proposed by Waxenberg.5 A 10-day moving average of the volume is calculated as the normal level, and a change in trend must be confirmed by a 20%

' Alex Saitta, "A Price and Volume-Based System," Technical Analysis of Stocks & Commodities (March 1996). 5 Howard K. Waxenberg, "Technical Analysis of Volume," Technical Analysis of Stocks & Commodities (March 1986).

increase in volume above this norm. (The 20% band acts as an additional smoothing filter, but may be replaced by a longer trend and smaller band.) Extremes in a trending move can be found at points that exceed approximately a 40% volume increase. Applied to the stock market, Waxenberg used the extreme volumes to indicate the end of a sell-off. To add more flexibility for longer test periods, and to adjust for volatility, Bollinger bands (based on about 2 standard deviations, or 95% probability) can be substituted for the fixed percentage bands.

Alternately, using 13 days of volume, subtract the total down volume from the total up volume. A plot of the results will serve as a momentum indicator from which overbought and oversold levels can be identified. If these values are unstable due to lack of liquidity, they may be smoothed using a short-term moving average.

Advance-Decline System

Advance and decline values, as with most volume figures, can be more useful if they are smoothed. By combining peak values of the net of smoothed advancing and declining shares with a directional move in price, Conners and Hayward have created a basic system structure that they named CHADTP6 (Conners-Hayward Advance-Decline Trading Patterns™). This system tries to identify reversal patterns by applying the following steps:

1. Add the past 5 days of advancing issues (New York Stock Exchange)

2. Add the past 5 days of declining issues (New York Stock Exchange)

3. Subtract the 5-day sum of declining issues (1) from the advancing issues (2)

4. Divide by 5 to get the average daily value

To trade using this oscillator, Conners and Hayward have determined that ±400 are the extreme levels where the values have been overbought and oversold. Based on this, we can apply the following rules to the S&P futures:

1. Sell when CHADTP > +400 and the SP trades .10 below the low of the previous day; buy when CHADTP < -400 and the SP trades .10 above the high of the previous day.

2. Note that the oscillator does not have to exceed its recent extremes on the day of the buy or sell signal. " ^

3. Timing is best if the signal corresponds to a newspaper commentary indicating "depressed volume" (which is seen as an excess of cash waiting to enter).

This system targets returns over a 5- to 7-day period. A drop in the oscillator, which results in values in the midrange, is an opportunity to exit, or a standard oscillator of price can be constructed to generate overbought and oversold signals within this time frame. An opposite entry signal would reverse the position. -

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