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Trading Volume Spikes

(part 3)

Research Results

From our analysis of eight years of historical S&P 500 volume data – and from the experimentation with more than 400 combinations of fast and slow VMAs and more than 20 PVO settings - we conclude that significant volume spikes tend to lead to trend reversals.

The PVO indicator makes it possible to establish critical volume spikes levels that have the potential to lead to trend reversals. We used the PVO to create a mechanical trading system that generates buy and sell signals.

Our research indicates that critical PVO levels are not constant but fluctuate over time. This is why they should thus be recalculated and adjusted on a regular basis. During long-term trends, an index will show a different reaction to volume surges depending on whether they appear near the onset of that trend (where a huge volume surge would be required to reverse it), in its middle (where a smaller volume spike would lead to a correction), or near its end (where it has become exhausted and is thus ripe for a reversal, even on a light volume surge). For the same reasons, critical PVO numbers may vary between supportive and resistive volume spikes.

Based on our review of historical volume data, we have found that the following settings are optimal for an analysis of the March-August 2005 timeframe:

• A 2-day VMA as fast the VMA;

• A 25-day VMA as the slow VMA;

• 15% as the critical level for resistive PVO values;

• 20% as the critical level for supportive PVO values.

The settings above generated the best returns for options trading. In Table 1 and Chart 2, we list those days where the PVO exceeded its critical levels.

While focusing on an analysis of the S&P 500, this does not imply that a trader would be restricted to trading the SPY. Since the S&P 500 index best describes broad market trends, an analysis of the S&P 500 can serve to trade any securities that generally move in concert with the broad market. In our specific example, we have applied the critical PVO data that was collected for the S&P 500 index to QQQQ options.

In order to evaluate the profitability of the system, we have simulated options trades according to the following rules. We:

1. Traded only options expiring 2 months from the time the trade was initiated;

2. Bought the cheapest in-the-money options;

3. Bought calls when the supportive PVO exceeded the critical level for supportive VMA spikes;

4. Sold calls when the resistive PVO exceeded the critical level for resistive VMA spikes, or at expiration, whichever came earlier;

5. Bought puts when the resistive PVO exceeded the critical level for resistive VMA spikes;

6. Sold puts when the supportive PVO exceeded the critical level for supportive VMA spikes, or at expiration, whichever came earlier.

For instance on June 24, as the S&P 500 was pushing lower, we noted a large supportive volume spike. We selected a 2-day VMA as the fast VMA and a 25-day VMA as the slow VMA. A PVO of 23% was calculated for this day, revealing that the average volume traded on June 23 and June 24 exceeded the average volume for the previous 25 trading days by 23.5%. Based on the supportive volume spike noted over these two sessions, we decided to purchase QQQIJ calls, which at the time were the cheapest at-the-money calls with an expiry date two months away. The decision to sell these calls (and take a profit of 89.74%) was subsequently made on July 17, when we noted a resistive volume spike with a (2/25) PVO reading of 15.9%.

Table 1:

QQQQ options trades outlined in Table 1 and S&P 500 VMA spikes.

S&P 500 Index (^GSPC)  Critical PVO Levels Fast VMA - 2-day VMA; Slow VMA - 25-day VMA Simulated QQQQ Options Trade Date PVO 5-day Change VMA Spike** Point on Chart Trading Decision Symbol Open Price Close Date Close Price Returns 7/21/2005 15.9% 0.54 R E Buy Puts QQQVN $1.26 08/25/2005* $1.65*  30.95% 6/24/2005 23.5% -25.39 S D Buy Calls QQQIJ $1.95 07/21/2005 $3.70  89.74% 6/17/2005 17.7% 18.85 R C Buy Puts QQQTL $0.90 06/24/2005 $1.25  38.89% 4/18/2005 25.7% -35.23 S B Buy Calls QAVGH $2.008 06/17/2005 $3.90  95.00% 4/15/2005 31.4% -38.58 S A Buy Calls QQCFI $1.32 06/17/2005 $3.20 142.42% **VMA Spikes: S - Supportive; R - Resistive *Date and price at the moment the data was compiled for article

Chart 2:	QQQQ options trades outlined in Table 1 and S&P 500 VMA spikes.

A relatively complex analysis of historical volume spikes and price movement data lies behind the apparent simplicity of the numbers presented above. For the period between March 3, 2005 and August 2005, the best results were achieved by applying a critical (2/25) PVO level of 15% for resistive volume spikes and a critical (2/25) PVO level of 20% for supportive volume spikes. Between August 2004 to March 2005, the best results were achieved with a critical (5/25) PVO level of 13% for resistive volume spikes and a critical (5/25) PVO level of 11% for supportive volume spikes. Trading results may be further improved with a proper understanding of volume, as well as access to real-time and historical volume analysis tools.

Conclusion

The above shows that it is possible to successfully trade options using a mechanical trading system that generates buy/sell signals based on an analysis of the volume patterns of the S&P 500 index. Traders are however still advised to use volume charts and to recalibrate critical PVO levels on a regular basis.

The following simple trading rules may assist traders in integrating PVO analysis into their personal trading systems:

• Get access to volume charts that allow you to use the PVO indicator, or at least two separate VMAs;

• Review historical volume data to determine PVO critical levels;

• Analyze current volume spikes to establish critical PVO levels on volume charts;

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