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Trading Volume Spikes

(part 1)


The smart money leaves tracks – volume picks up the trail.

Volume is one of the most mysterious indicators in technical analysis. Numerous different indicators are applied to price, but only a few to volume.

In the research presented below, we analyzed the historical volume patterns of the S&P 500 index. Our goal was to find relationships between volume spikes and index reversal points – and to build a trading system based on our findings. We analyzed volume spikes using the Percentage Volume Oscillator (PVO). Based on our research, we were able to determine critical threshold levels and formulate simple trading rules and that could be successfully applied to the trading of options.

Before discussing our research results, we would like to clarify a number of issues: (1) why do we analyze indexes (the S&P 500 in particular)? (2) Why analyze volume?; (3) Why use the PVO as our key indicator to evaluate volume spikes?

Why Analyze Indexes

Individual stocks tend to move with the broad market. If a particular index pushes higher, a majority of its constituent stocks will usually move along in unison. Indexes are thus best suited to characterizing broad market trends - that is the reason our volume analysis focuses on the major U.S. indexes.

Among the major U.S. indexes, the S&P 500 is generally considered one of the best gauges of market activity. The S&P 500's volume exceeds that of the DJI index, the NASDAQ 100 index, and other popular U.S. indexes. In terms of volume output, the S&P 500 is only exceeded by the NYSE Composite, the NASDAQ Composite, the Russell 1000, and the Russell 2000. However, compared to these indexes, the S&P 500 comprises a more manageable number of constituent stocks.

Why Analyze Volume

Volume is defined as the number of buy and sell transactions over a specific period of time. By analyzing volume transactions over any given timeframe, one can make a determination as to how actively a stock (or a basket of equities) was traded. For instance, if a dramatic increase in volume is noted on a representative index (such as the S&P 500), it is clear that such significant trading activity is spread across the broad market rather than being isolated to a specific sector or individual equity.

In our research, we look for significant surges in volume we call “volume spikes”. Depending on the directional price movement on an index as the volume surge is taking place, we classify volume spikes as Resistive Volume Spikes or Supportive Volume Spikes. Resistive volume spikes occur when volume surges as an index is moving higher; conversely, supportive volume spikes are volume surges that occur as an index is pushing lower.

Our research shows that index reversals are frequently preceded by one or several significant volume spikes. When such spikes appear after a prolonged trend run, a turnaround is often about to occur on the index. The exact timing of a reversal depends on the magnitude (height or size) and duration of the volume spike. These characteristics also play a crucial role in determining whether a reversal is likely to remain short-lived, or if it might lead to an extended run.

While an index's uptrend is still in motion, the appearance of large resistive volume surges indicates that large amounts of high-priced shares are changing hands. Such a wholesale transfer of stock leads to shifts in the supply / demand balance, which can ultimately induce trend reversals to the downside. The opposite applies to supportive volume spikes that appear during a protracted downtrend. We have found that in both the bullish and the bearish case, the greater a volume spike's magnitude and the longer its duration, the higher its impact on the index.

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