How to Read Volume

See how two trading systems use volume to better understand price changes.

For traders and investors, volume does more than measure how many shares are changing hands between market participants within a given time period. With the right interpretation, volume can be a way to read the mood and psychology of the market, discover the strategies of large investors, and put price changes in context.

Toni Turner, an independent trader and best-selling author of A Beginner’s Guide to Short-Term Trading (Adams Media, 2008), says that she has had made more trading profits “by concentrating on reading volume than on any other indicator. It can show extreme enthusiasm or extreme fear and panic.”

The challenge, she cautions, is interpreting the data. Volume reflects demand, but doesn’t always tell you if it’s coming from buyers or sellers, or from large players or small. There are dozens of systems to interpret volume data into trading signals, here is how volume plays into a couple of popular systems: the CAN SLIM® investing system and The Wyckoff method.

The CAN SLIM Investment System

Volume, combined with price, is “critical to spotting emerging trends,” says Chris Gessel, executive editor and chief strategy officer of Investor’s Business Daily. He describes how price and volume are woven into the CAN SLIM investing system, a top-performing strategy recognized by the American Association of Individual Investors (AAII). The CAN SLIM system was developed by William J. O’Neil, chairman and founder of IBD and author of the best-selling book, How to Make Money in Stocks.

“Price and volume are the key to IBD’s market analysis,” says Gessel. “It’s how we spot new up-trends as well as corrections before they are widely known.”

One benefit of volume is that it can give you signals of what the major institutional investors are doing. Gessel says that IBD looks for stocks that are ending a period with little or no price change and make a big price move on high volume. “This may show that institutional investors are driving that move. You want to be on the same side as big investors.”

Because it can take institutional investors weeks or months to complete their purchases, Gessel says that “individual investors have a chance to piggy-back those purchases and ride those price run-ups.” If you watch price and volume carefully, he suggests, you can also detect clues it is time to get out.

Another key benefit to watching volume is to understand the general trend of the market. Since three quarters of stocks follow the general market trend, Gessel notes, it’s crucial you learn how to read the market action each day. Generally, stronger volume indicates a more important price change. “With market averages, we compare the day’s volume total with the prior sessions. An index that falls in heavier volume than the day before is generally negative. With stocks, you want to see how the daily volume total compares with average daily volume. A stock rising in above average volume is generally positive.”

One key rule, according to Gessel, is that “a breakout should come on volume at least 50% percent higher than average.” For example, look at the chart of Nu Skin (NYSE:NUS):

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Chart is for illustrative purposes only.

“Nu Skin built a flat base from the beginning of August to the beginning of October,” Gessel points out, “never correcting more than 11%. It then broke out in huge volume on October 2, en route to a 50% gain in just two months. It’s been building another base since December.”

The biggest danger, Gessel warns, is that you don’t apply these volume rules to thinly traded stocks. “Stocks that trade under 400,000 shares a day are more volatile. It’s easy to get shaken out of a stock when it trades relatively few shares.”

Finally, Gessel suggests that investors and traders look at the fundamentals as well as charts. “Fundamentals lead you to the right stocks. Charts tell you when exactly to buy and sell them.”

The Wyckoff Method

The CAN SLIM system isn’t the only trading system that uses volume to interpret price changes. Richard Wyckoff developed a well-known trading method based on price and volume behavior. One of the leading practitioners of this method, David Weis, is an independent trader and co-author of Charting the Stock Market: The Wyckoff Method. “As a trader,” Weis says, “I look for changes in behavior that indicate when either the buyers or sellers are gaining the upper hand.”

One Wyckoff technique involves looking for a buying or selling climax. A trader looks for a larger than normal price range and heavy volume to spot a trend change. When using this system, the trader establishes a stock position after the price moves past support or resistance if it looks like the trend is reversing. “If there is little or no downward follow through when the price passes support, you can go long at the danger point where the risk is the least,” Weis says. He adds that failed breakouts above resistance can be used for shorting.

Weis admits he uses no mathematical indicators. Instead, his tools include the length of the daily range, the position of the close, and volume. “I’m looking for ending action which reflects a climatic top or bottom,” he suggests.

You may be able to recognize the climatic change by an unusual amount of volume, he notes, usually associated with a wide price range for the day. Wyckoff referred to this condition as hypodermics, when a market goes straight up. The chart of United States Steel (NYSE: X displayed below) is a classic example.

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Chart is for illustrative purposes only.

“You see that bar on January 8?” Weis points out. “There hadn’t been a bar of that length for almost a year. Both the range and the volume were the largest since the price rise off the November 2009 low began.” For the next two days, the market moved lower on the increased volume. “All of these changes in behavior reflect topping action in the stock,” he says. “It’s typical climatic behavior.”

For Weis, the large range and heavy volume after a prolonged advance indicate the large operators are unloading their long positions under cover of public buying. “When the whole world is buying, it’s the easiest time to unload long positions undetected,” he says.

The rally of U.S. Steel on January 19 was accompanied by volume that was much lower than January 8. “This was a low-volume secondary test of the buying climax. When you see such climatic behavior, close out long positions. Aggressive traders should go short and place buy stops above the high.”

Weis admits it takes practice to learn how to read bar charts. As noted above, the basic ingredients are the daily range, the position of the close, and the volume. Another important ingredient, he says, is the interaction between the opening price and the day’s range. “If price opens below the previous three days’ lows,” he says, “and then rallies above unchanged only to fall back to close on the low, we know the buying effort failed on that day.”

It also helps to learn the meaning of some of the less dramatic-looking price bars. “If the daily range is narrow, and goes under the low of several days on heavy volume,” Weis explains, “and rebounds to close unchanged, we know some large buyers are holding the bag open to trap the sellers.” Put another way, the volume shows increased effort but the narrow range reflects little reward.

One of the mistakes many people make, Weis says, is to quantify volume into hard and fast rules. “These rules are guidelines but they don’t fit every situation. There are times when the market goes down on low volume because there is no demand. Conversely, prices can rally on low volume due to a lack of supply.”

Ignore Volume At Your Own Peril

Not studying volume is akin to “putting my hands behind my back and blindfolding me,” quips Turner. “Volume tells you the psychology of the market. It’s also one of the only indicators that is not derived from price, so it gives you a second opinion.” She says the goal for her is watching volume “from the bushes and pounce before everyone else.” No matter which method you use to study volume, there is little doubt that volume combined with price cannot be ignored by informed investors and traders.