Volume can give many clues as to the strength of price movement and even information as to the thoughts and actions of the masses involved in a security. The conventional wisdom for volume tells us that we need increasing volume, or at least steady volume, in order to maintain a trend. Weakening volume could signal trend weakness or even a potential reversal. Look at the following chart. Notice how the declining volume as we approached the supply level helped to signal an exit for longs or to set up a trade to the short side.
But what happens when volume is too great? In a previous article, “Find the Fool!,” May 4, 2010, I discussed how to identify amateurs jumping in late to a trend anticipating a breakout in price. Most books will tell you to watch for high volume on a breakout and to trade those breakouts. However, if you have been trading for any length of time, you will realize that this is usually a sucker play as most breakouts fail or at least retest before continuing. Remember, stocks need aggressive buyers to keep prices rising. If you see a large candle just before a supply or a demand level, that shows that most traders have entered early in anticipation and there is no one left to push prices higher.
What are we supposed to do when we do see a violation of the supply or demand level with high volume? Well, patience is your best friend in this case. As I mentioned, most breakouts will fail or even retrace before continuing. Wait and watch the follow up of price at these levels. The worst thing that happens is that you miss a move and have to enter on a later retracement. The more likely thing to happen is that you will save yourself from making a bad trade and donating money to the markets.
On an actual breakout, you should see price close above supply levels or below demand levels. You would also expect the following candles to confirm the trend with higher highs or lower lows. Look at the false breakouts in the following chart. See how price fails to close at a lower level as the amateurs are trapped into the stock.
Finally, let’s look at capitulation. This is essentially a blow off of the buyers or sellers in a trend. Notice how the volume dramatically increases after a rise in price. Sometimes there is a gap to the upside where buyers panic for fear of missing a breakout. However, the topping tail or high volume shows that they are buying at a level where there is almost the same aggression being shown by sellers. This will prevent prices from climbing. The trend officially ends with a gap down that triggers stops from amateurs foolish enough to be caught by the bull trap.
So we must pay close attention to the actions of traders and investors at the supply and demand levels. Volume can give us a great view into their actions. We discuss this in much more detail in our Professional Trader courses. Enroll at your local Online Trading Academy center to learn more about reading price and volume. Until next time, trade safe and trade well!