What traders need to know about volume

December 1, 2015 09:00 AM

Many new traders do not analyze volume properly. They simply cannot wrap their minds around it, and this can persist for years, even for experienced technicians. It is a common problem; every time you think you understood volume, price would go up, volume would go up, you buy and your position collapses. 

Why? The reason is simple. Volume is an after-the-fact item. The volume that was often depended on for direction was exhaustive volume. Traders need to understand the difference between exhaustive volume and confirmation volume. 

Following failure after failure, many traders become so frustrated that they choose to ignore volume completely. That’s no good either. It’s analogous to a  2,000-pound bull in your living room. You can pretend that it is not there, but only as long as you stay out of its way. 

It should be noted that it takes reasonable volatility to make a market behave. Volume is an indicator that reflects the mood of the market and the collective psychology of active traders. Knowledge of volume will not only make you money, but it will help you keep from losing money. It takes steady volume to make any market behave and to print honest chart patterns.

Volume & volatility

Strong volatility in an advancing market tells us that market participants feel comfortable with buying and holding positions, as increasingly more traders see an up market as being confirmed and want to join. The important thing is that any time traders pile onto an advancing move in growing numbers, they have to pay increasingly higher prices to get a position. 

Conversely, the opposite would be true in a declining move. Any time buying pressure is weakening and we are seeing more volume on dips than on the rallies, it is a heads-up that sellers are becoming more aggressive. Generally speaking, we find that in bear markets, volume is higher when prices decline than when they rally. When the public begins to see the market as collapsing, they sell at ever-lower prices just to get out.

Volume is the probability signal that confirms moves and warns of reversals. Generally speaking, it confirms a trade and you should never be overly excited about exiting when you have gently expanding volume. That includes when price is approaching a support or resistance level. Any time price action is accompanied by steady or increasing volume it is normally a confirmation of the move at hand and is an indication that the move is likely to continue. The bottom line is that volume is the best tool we have to monitor market mood. It is an umbrella under which all probability signals reside, and we always need to be aware of it.

Price resolution

You must keep in mind that volume follows price, it does not create it. While price essentially leads volume, it does not always lead it up. The key to understanding volume is that volume is not nearly as important as are volume and price together.

Every move eventually will resolve and volume is our heads-up to that occurrence. Without solid volume, nearly every move will fail because a lack of volume is indicative of a trade that has no players. Nevertheless, it is always an interpretive probability signal. 

Price and volume generally  can be interpreted as shown in “Volume & price” (below). This is the simple foundation of interpreting volume. Let’s look at each relationship in more detail.


A. 1: Prices up with volume up, the market is BULLISH.

With price action making new highs, steady volume is telling us that the move is widely accepted and more and more traders want to get aboard and are willing to pay ever-higher prices to do so (see “Strong coffee,” below). However, if volume accelerates abnormally and the price action becomes overbought followed by a sharp reduction of volume, beware. A market reversal is probably at hand.

A caveat: Be careful that the move does not produce so much volume that it fails. Unusually heavy volume often occurs as a top is reached and existing positions are covered and demand exhausts itself. Heavy volume may be telling us that while the dynamic trend appears strong, the demand is leaving a shortage of offsetting trades in its wake.


A. 2: Prices up with volume down, the market is BEARISH.

At best, decreasing volume should be seen as indecision. At worst, it should be viewed as the warning of an impending reversal. Any time we have a reduction in volume, we have a reduction in liquidity. 
If price action is up on lowering volume, the market will often reverse, because volume is telling us that we are simply running out of buyers and the rally is failing to attract new players. 

A caveat: Low volume near the latest high of a strong move often occurs as the move just catches its breath and prepares to continue. At times like that, it is often best to just get out and let the market commit.


B. 1: Prices down with volume up, the market is BEARISH.

Lower prices on increasing volume usually represent a sharply declining market (see “Follow the money,” below). Volume normally increases during the middle of down markets, and if it continues to increase it usually is an indication that the decline will continue. Increasing volume is occurring because increasing levels of fear are now infecting the market. However, if volume accelerates abnormally, and the price action becomes oversold followed by a sharp reduction of volume, beware. A reversal is probably at hand.

A caveat: The trouble is that we never know for sure if the selling will continue and so we must rely on other probability signals upon which to base a reversal.


B. 2: Prices down with volume down, the market is BULLISH.

While volume usually increases somewhat during the middle of most bearish moves, it normally dries up right before their reversals. Decreasing volume is an indication that nobody wants to sell at these levels.
It  always should be kept in mind that volume is a two-edged sword that can kill as well as confirm. The key words here are “unusually heavy.” Any time you see extreme volume, it is often time to tighten your soft stop. However, that is a subjective call. It is like a pretty piece of art. Hard to define, but something you usually recognize whenever you see it.

The biggest problem we run into when interpreting volume is that price action does not always respond to volume in a pre-ordained manner. In other words, it occasionally can produce results contrary to what the same behavior did before. All of this is a nice way of saying that understanding volume is both art and science, with art in this instance playing the major role. 

A caveat: Keep in mind that any time volume begins to deteriorate, it is an indication that belief is lacking. A lack of volume always indicates that there exists the real possibility of a retracement. 

Reversal patterns

Bar structure and volume: It is always a heads-up when we see abnormal bar structure coupled with non-typical volume. Price bars such as a Doji or a Harami Cross when coupled with decreasing volume often are indicators of impending reversals. 

Volume in spikes: Spikes are an example of mass insanity being graphically displayed on a price chart. They are the result of an abnormally high number of orders being laid onto the market with the market being unable to offset them at current prices. Spikes often are accompanied by two, three or maybe even four times the normal volume.

Volume in congesting markets: Volume tends to provide a good insight into the resolution of congesting or consolidating chart patterns. Most traders tend to avoid markets that lack conviction and prefer to wait until they can see proof of the market’s directional probability. Whenever the working chart tells us that the volatility and the concluding move are both in neutral, we need to be patient and watch for an increase in volume to confirm a resolution.

Any time that it appears that the price action is producing a congestive chart pattern, odds are that you might be better off to get out and just re-enter once the price action continues and is confirmed by volume. Either way that you look at it, if a stock or futures contract is suffering from a significant reduction in liquidity, it is definitely not the time to start playing video games on your cell phone.

Open interest

Open interest defines futures and commodities contracts. A common misconception of neophytes is that the open interest of futures is the same thing as the volume that is generated when trading stocks. Nothing could be further from the truth. They are two totally different animals. Open interest is the total number of contracts in existence for a particular contract. 

While the futures exchanges report volume on an intraday basis, they do not report open interest until the next day, so open interest is not timely for the short-term commodity trader. What is important to understand is that the volume of commodities, as it is usually displayed, is the aggregate volume for all the contracts of that particular futures contract, and not just the contract month that you may be trading.

Nonetheless, if you trade commodities, while the volume is a rather moot item, the open interest provides you with a very strong insight into futures’ fundamentals (see “Open interest & price,” below).

Bottom line

Essentially, if there is heavier volume on up moves than on down moves, buyers are aggressive and additional moves to the upside will be more than likely. On the other hand, if volume is heavier on down moves, the market will usually continue lower. As increasingly more participants come into the market to buy (sell), their actions will always result in increased volume. Conversely, when the traders become afraid and withdraw their support from the market, volume dries up. For this reason, volume is an important ingredient in the interpretation of all moves. While studying the effects of volume can be complex, in simple terms, if there is more volume behind what the technical price action is showing you based on chart patterns and other technical indicators, those indicators are more valid.

About the Author

Bill DeBuse has been engaged with the markets since 1959 and is presently a proprietary trader for a family foundation.