Now that we've looked at how sell signals are generated, it's time to switch to buy signals. Once again, the key factor is a comparison of Ord-Volume (average daily volume).
A buy signal is triggered when a stock hits a minor new low and Ord-Volume on the down leg shrinks by approximately 50 percent or greater against the previous down leg or previous up leg; the stock then closes above the previous low. Both conditions indicate the stock is in a strong position. Confirmation of a bottom is produced when Ord-Volume increases by 50 percent or more on the up leg after the bottom compared to the down leg going into the bottom.
Let's take a look at how this works using a hypothetical example: stock "EDF." Figure 3.18 shows EDF declines to $50 a share on Ord-Volume of 100 million shares.
In this example, EDF rallies and then declines again—with Ord-Volume on the second down leg of 25 million shares, putting in a new low at $49.50. You can see that the average daily volume is 75 percent less on the second down leg compared with the first. In this instance, a buy signal is triggered on a close above the previous low of $50 a share. Because the energy in this stock had switched from the downside to the upside, Ord-Volume increases on the subsequent up leg—in this instance a 300 percent increase to 75 million shares compared with the volume of the previous down leg of 25 million shares.
Figure 3.19 shows hypothetical stock "MNO" with average daily volume on a down leg of 100 million shares to a low of $50 a share, then a rally and a break to a new low of $49.50 a share. Volume on that second down leg declined by 50 percent compared with the previous down leg. The rally from the low at $49.50 had a 50 percent increase in Ord-Volume compared to previous down leg and confirmed the bottom.
Ord-Volume shrinks 50%
Ord-Volume shrinks 50%
Now compare the performance of the two stocks, EDF and MNO. For the first stock, EDF, average daily volume on two subsequent down legs declined by 75 percent. On MNO, the average daily volume declined by 50 percent. This shows that the energy to the downside was less on EDF than MNO; therefore, EDF had a stronger buy signal setup. EDF also had a 300 percent increase in Ord-Volume after the buy signal compared to MNO's 50 percent increase, which showed that EDF should outperform MNO on the rally phase.
To recap, the definition of a buy signal using the Ord-Volume methodology is: A buy signal is triggered when a stock closes above a previous low and Ord-Volume on the down leg declines by 50 percent or more compared with the previous up leg or previous down leg. Both conditions indicate the stock is in a strong position.
Figure 3.20 illustrates the buy signal concept graphically. Here, hypothetical stock "AAA" rallies from a low of $50 a share with Ord-volume on
Ord-Volume ahrEnka 75%
Ord-Volume ahrEnka 75%
an up leg of 100 million shares, and then a decline to a new low at $49.50 on Ord-Volume of 25 million shares.
This example illustrates the rule for determining a buy signal using Ord-Volume. There is a decline in average daily volume on a down leg of 50 percent or more to confirm that a bottom is in place and that energy has switched to the upside. In fact, Ord-Volume on the up leg after the buy signal at 75 million shares is three times the volume on the previous down volume. Comparing the performance of AAA after the bottom is put in with stock MNO, you can see that AAA is a much stronger stock given the magnitude of the force to the upside.
Volume relationships between up legs and down legs are all about energy and how hard that force is pushing up or down. Understanding these Ord-Volume relationships, traders will more easily confirm or deny buy and sell setups. They also will see stronger and weaker buy and sell signals, enabling them to pick the stronger setups.
Figure 3.21 is an Ord-Volume chart of BGO, showing the average daily volume for the up legs and down legs as significant highs and lows are put in the stock.
Focus on the area in Figure 3.21 labeled "low was made here." This time frame is more detailed in Figure 3.22. Let's start with the down leg from the $2.95 price level in late June 2004. Ord-Volume on this down leg was 1.94 million shares.
Compare that down leg volume of 1.94 million shares with the Ord-Volume of the previous down leg of 4.96 million shares. This is a 61 percent decline in Ord-Volume and a bullish sign. A close above the previous low of $2.14 a share triggers a buy signal. On the rally up leg from the low, Ord-Volume expands to 2.79 million shares, compared with the previous down leg, showing that energy has switched from downward to upward. Once again, you can see how volume pushes price.
Figure 3.23 is a candlestick chart of 8 X 8 Inc. (EGHT). The price pattern shows a steady decline to a low of $1.32 and then a strong upward move.
Just looking at the candlestick chart alone, going into the $1.50 price level you would have no evidence that this would be the low (although you can obviously see that in hindsight). In real time, however, all you would have seen is a sharp decline in price. To get an indication that a low is being put in place, you would need to look at Ord-Volume, as depicted in Figure 3.24.
THE BULLISH SETUP
The Ord-Volume analysis shows that volume is shrinking as the low is put in place. In the next chapter, we will explore how volume should behave as new lows or new highs are made. But for now, we will reply on price and volume alone.
As EGHT broke to a new low at $1.32, a trader would have see that Ord-Volume on the final down leg at 264,000 shares (Figure 3.24) was about half compared with the previous Ord-Volume down leg of 504,000 shares, and nearly 50 percent less than the Ord-Volume for the previous up leg of 553,000. This is a trigger for a bullish setup. The buy signal was triggered on a close above the previous low of $1.58. Notice that on the next up leg Ord-Volume explodes with a 680 percent increase in volume on the up leg to 1.80 million shares compared with the previous down leg volume of 264,000. This example shows how important it is for Ord-Volume to expand after a buy signal is triggered to confirm an uptrend. Further, in this example, an increase in Ord-Volume of this magnitude (nearly seven-fold compared with the previous down leg) implies that the rally will generate a big increase in price. The stock was up 255 percent in about one month.
A huge volume increase means there is huge energy, and that translates into a potential for a huge price move. Think back to the car analogy from the beginning of the chapter. When you push on the gas pedal a little, the car accelerates slowly. When you floor it, the car takes off rapidly.
Figure 3.25 shows EGHT in a different time frame at a different low. On the down leg going into the low at $0.65, Ord-Volume declined by 46 percent to 361,000 compared with the previous up leg volume of 642,000, as well as the previous down leg volume of 642,000. This triggers a bullish setup.
Ideally, the decline in Ord-Volume on a down leg going into a low— compared with a previous up leg or down leg—would be 50 percent or more. In the EGHT example, the 46 percent decline was still a bullish sign, and a close above the previous low at $0.85 triggered a buy signal. What Ord-Volume identified going into the $0.65 low was that the downward force had evaporated, and there was no more energy pushing the stock lower.
The stock's ability to close above its previous lows showed what little buying it took to move the stock higher. This is simply how the market works. When downward force evaporates because sellers of the stock have retreated to the sidelines, the stock will either go sideways or go up. What Ord-Volume identified in the case of EGHT was that the downward force had ended.
After the buy signal was triggered on a close above $0.85 a share, the stock drifted higher. As Figure 3.25 showed, volume began to expand
Ord-Volume Analysis Shows a Bullish Setup in 8 X 8 (EGHT)
Ord-Volume Analysis Shows a Bullish Setup in 8 X 8 (EGHT)
toward mid-September and stayed strong into mid-November. Notice the expansion of volume on the rally phase after the buy signal on the current example, which is not as strong as the previous buy signal in Figure 3.24. The reason is in the previous example EGHT had a volume explosion of 680 percent after the buy signal, and EGHT jumped 256 percent in about a month.
In the current example, EGHT showed volume expanded 60 percent and the stock rallied 230 percent after the buy signal, but that took nearly three months. What this shows is the relationship of expanding volume of the same stock at two different time frames.
The higher energy—meaning a bigger the percentage increase in Ord-Volume on a rally leg after the buy signal—shown in Figure 3.24 produced faster results and a bigger percentage gain compared to the buy signal in Figure 3.25. It's all about the physics of stocks; the greater the energy force, the farther stocks go.
Figure 3.26 examines the continuation of the move in EGHT after the up phase ends. After a high was made at $1.96 a share, Ord-Volume on the down leg increased by 35 percent compared to the previous up leg, which suggested that energy may have switched from up to down. What this indicated was that either a top was made, or that a sideways consolidation is about to begin. There are three possible directions that a stock can move in: up, down, or sideways. With a 35 percent increase in Ord-Volume
on the down leg, the up phase was likely over for EGHT. If someone was holding the stock at this point, it would be time to look for an exit.
One clue may have been the smaller swings in EGHT near the highs. However, if a trader had not looked at those smaller swings, he might still be holding this stock. The bigger swing down from the high of $1.96 with increased Ord-Volume suggested that a large-degree consolidation or a down swing was beginning.
I have based a lot of my volume analysis on the work of trading master Richard Wyckoff, who was famous in the 1930s for his abilities to forecast stocks (as I explained in Chapter 1). Wyckoff was one of the first to find the price-volume relationship. What I have done is expanded on Wyckoff's ideas, simplified some, and added new ones. I made the Ord-Volume discovery by studying Wyckoff's methods. We will cover some of his techniques in the next chapter.
Going back to the last example of EGHT, the 35 percent increase in Ord-Volume on the down leg off the $1.96 high suggested that it was time to exit the stock. Wyckoff would have called this expanded volume a "sign of weakness" (SOW). After a SOW, there is usually about a 50 percent retracement back toward the high, and this would be a good place to sell EGHT.
In the examples in this chapter, volume provided clues when a stock was nearing a low or a high. To successfully set up trades, a thorough understanding of volume should be in your trading arsenal. Thinking of volume as energy, one will understand how volume pushes price.
Trades that are set up by volume analysis, however, need to follow the signals of the general market. Don't expect to be profitable on bullish signals on stocks if the general market is in a downtrend, along with the sectors you are trading. And, don't expect your short signals on a stock to be profitable if the general market and the sectors you are trading are in an uptrend.
For the volume setup to work to your advantage, both the general market and your sector should be going in your direction. It's common sense—and that has a lot to do with stock trading.
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