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
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?
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.
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
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
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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