From the January 01, 2011 issue of Futures Magazine • Subscribe!

Trend reversal spotting

All traders experience it. You have selected the right stock, entered the position perfectly, watched the stock take off and sat back as profits rapidly mounted. Waves of traders latch onto the trend in place, attracting more to take part. Volume surges, creating additional interest from other like-minded speculators.

Then prices reverse. Traders on the sidelines jump on board en masse at the prospect of getting in at a better price, spiking the stock’s price to ever greater heights, with volume soaring two or more times normal levels. After this final push, the buyers are exhausted. There simply are no more. Those traders and investors who got in at the end of the move realize they got in at the wrong time and panic sets in. Upon this icy realization, the trend falls apart while all the profits you watched pile up evaporate like dew on a mid-July morning. If you knew the warning signs, you could have gotten out with most of your profits intact. The key is understanding the relationship between price and volume.


Volume basics

Volume is to the markets what rocket fuel is to the space shuttle. It’s the stuff that can cause stock prices to advance or decline and, for many traders, is the single biggest determinant on whether to participate in a stock’s trend.

The amount of trading volume in a particular stock reveals the interest that other investors or traders have in it. It also reflects a stock’s liquidity, which indicates how easily you can enter or exit a position at your price.

Volume also can be the catalyst that attracts multitudes of buyers or sellers that will cause a stock to rise or fall in value according to the laws of supply and demand. This activity yields profits or, to those who fail to consider what volume is communicating, losses. Volume is a compass to the direction of stock price trend.

While volume is a key factor in timing the trading of a trend, it also can reveal where price is likely to reverse. Knowing these key price points is a function of being aware of the significant high or low points of price and combining that awareness with a knowledge of how price and volume interact, which can give you a huge edge in the markets.


P/V relationship

The relationship between price and volume is a familiar one. If the relationship remains symmetrical, they will move forward and progress together. But, if one of the two displays a much different pattern than in the recent past, then it signifies a change.

This is often demonstrated with individual stocks. If trading volume begins to surge at price highs or lows to levels that are two or more times the 20-day average volume, something is up. This type of price/volume activity at these key levels can reveal that traders are over-committing to their positions, trying to push or will the stock in the desired direction.

This last-ditch surge in volume is referred to as climactic volume, which occurs after a strong move in a given direction and signifies the end of one trend while signaling the beginning of a countertrend move (see "Spike & stall"). Different from breakout volume, when a surge pushes a stock upward or downward through a significant support or resistance level, climactic trading volume is the result of a final push of traders committing to one final wave of buying or selling to continue a stock’s trend. This type of trading activity is the result of fear or greed manifesting itself while revealing the last gasp of a stock that has run its course. These moments are where price and volume have reached their maximum divergence and indicate a price reversal is likely.

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At this point, the smart trader knows it’s a sign to lighten his position or cash out, while at the same time looking for a new trend to emerge. Climactic volume serves as both a warning signal and an alert for new trading opportunities.


Points of reversal

When a stock is setting up to break out of a tight trading range, normal volume moves in tandem with price, typically moving with price closing in the upper quarter of its trading range, and then expanding daily trading ranges in the direction of the dominant trend. When price and volume move this way, it reveals their inherent harmony.

Warning signs include trading days that have high trading volume but a price range that doesn’t reflect this harmony. For example, if a stock is in a bullish trend and there is a huge spike in trading volume but the price bar doesn’t have a large range or closes below the open, something is wrong.

Conversely, if the stock is in a down trend and experiences large flows of selling with spikes in trading volume but closes near or above its opening price, it indicates a possible reversal. This is especially true if the stock has been experiencing a strong downward trend and is forming a bottoming pattern (see "Patterns & volume").

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Tight relationship

A close study of the relationship between price and volume can reveal trend reversals. It shows both the strength and weakness of the trend. Trend trading is a safe and bankable method of making steady profits, but nearly always incurs significant losses when the trend reverses. Having the ability to get out at or near the reversal point through analyzing climactic volume gives you a big edge.

And, just as important, a study of climactic volume can also help you catch new trends earlier in their formation, giving you the opportunity to exploit them for huge potential gains.


Billy Williams is a 20-year veteran trader specializing in momentum trading of both stocks and options. Read his market commentary at www.StockOptionSystem.com or his newsletter on ETF Trading at
www.FinanceBanter.com.

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