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Smart investing: When to buy & sell shares

March 26, 2010 12:02 IST

In the stock market, volume refers to the number of shares that change hands on a given day.  In commodity markets, it refers to the number of contracts traded.

Each transaction is the result of the meeting of demand, on the one hand, with supply on the other.

When demand exceeds supply, prices tend to rise.  Conversely, when supply exceeds demand, prices tend to fall.

Therefore, volume occurring during price advances is termed "demand volume"; volume occurring during price declines is "supply volume".

We study volume because it can be a measure of supply and demand.  There are many ways to visualize the relationship of volume and prices.  Some analysts think of volume as a gauge of market pressure.

Our own particular "picture" is this: Imagine you have turned on the garden hose and are pointing it skyward. You toss a plastic ball into the stream of water, and it shoots upward.

But if you turn down the water pressure, what happens to the ball? It continues upward from its own momen­tum for a second or two, but then falls back. It can't continue higher until you increase the water pressure.

Like the plastic ball, prices need increasing volume to continue higher. When prices move higher, but on diminished volume, they are likely to fall back.

The basic rules of volume analysis are as follows:

1. When prices are rising and volume is increasing, the present trend will continue, i.e., prices will continue to rise.

2.When prices are rising and volume is decreasing, the present trend is not likely to continue, i.e., the price rise will decelerate and then turn downward.

3.When prices are falling and volume is increasing, the present trend will continue, i.e., prices will continue to fall.

4.When prices are falling and volume is decreasing, the present trend is not likely to continue, i.e., the price decline will decelerate and then prices will turn upward.

5.When volume is not rising or falling, the effect on price is neutral.

How can we employ this concept in practical applications? Let's assume XYZ stock has been in a trading range for several weeks with an average daily volume of 50,000 shares changing hands.

Prices now begin to move higher and the daily volume picks up to 80,000 shares.  We are justified in believing that prices will continue higher, fuelled by "demand volume." Sure enough, prices do continue to move higher on strong volume over the next three weeks.

Then, in the fourth week, prices tumble and lose 30% of their previous gains.  Do we sell the stock or hold? Again, the clue lies in the volume picture. We notice that during the fallback, XYZ stock has been trading only 40,000 shares per day.

Therefore using our volume rules, we can surmise that this is only a temporary reaction. What might be actually happening in the market place? Any number of factors could be contributing to the fall in prices. Early buyers could be taking profits or any new buyers could be waiting for a setback before buying.

All of these are natural, healthy reasons for a correction and, therefore, we have no reason to abandon our position at this point -- unless we notice that volume is beginning to increase on down days.

As expected, in week 5, prices begin shooting up again on volume averaging 90,000 shares a day. Week 6 continues in the same way. Week 7 brings a reaction in prices, but again on reduced volume of 50,000 shares per day.

We hold our stock. Week 8 sees prices rising again to new highs, but volume - oddly enough - is only averaging 60,000 shares per day. This is a clear-cut warning signal: Demand volume is drying up.

New demand may still come into the market if favorable news events occur, but if not, prices are in danger.  Remember, prices can only go up if fueled by rising demand volume, but if they fail to get that extra boost, they can fall under their own weight.

As expected, prices turn down the next few days on heavy volume; we sell our stock.

The XYZ example represents only one possible scenario. What if prices have been in a sideways trading range and then begin to fall on low volume. Would we consider this move false? Not necessarily.

Although prices must be accompanied by strong volume to confirm an up move, down moves often begin on light volume. Remember, a market can fall under its own weight; and it is important to be aware that volume usually tends to be lighter when prices are falling than when rising.

In the XYZ example, the last phase or "leg" of the move was on light volume. But oddly enough, tops may also be formed on heavy volume - a "climax" which usually occurs after a market has been moving up for a considerable amount of time.

This is a contradiction which reflects a classical problem which has puzzled analysts for many years and there is no complete solution. However, if you closely observe the market action it may help you deter­mine if it is a climax or not.

Typically, prices make new highs in the morning on heavy volume, but by afternoon, prices are substantially lower while volume is still heavy, producing a reversal day. This is a classic example of "distribution" - a period when existing owners of the stock are dumping their shares and taking profits, while Johnny-Come-Latelies are buying it at the top.

The previous owners who have been buying for weeks have more stock to distribute than the Latelies can handle. So, supply overcomes demand, prices crash, and the new buyers are left holding the bag. Stocks are said to be "moving from strong hands to weak hands."

How do we graphically represent volume? The traditional way has been in the form of a bar chart directly beneath the price chart (Figure 1).

However, you need not be so limited.  You can also look at volume in many different ways. When looking at the actual volume itself, I prefer to chart it as a continuous line, rather than a bar chart. Notice also, I leave more space between each day's price so 1 can readily identify the corresponding change in volume for each day:

Some analysts feel that the absolute change in volume from day to day is not as important as the deviation from the current average volume. Again, by using your computer as an analytical tool, you can be way ahead of those who must rely only on commercially produced charts.

Here's what you do: First, run a 10-day moving average on volume. Then run a continuous line of current volume on the same graph. If the current volume line is above the 10-day moving average, we know that the volume is increasing. Conversely, when the current volume is below the 10-day moving average, volume is decreasing:

In sum, an understanding of volume patterns adds a third dimension to our analysis. Now we're ready to begin to apply these concepts to key patterns which appear on our charts.

(Extract from Timing the Market: How to Profit in Bull and Bear Markets with Technical Analysis by Curtis M. Arnold. Published by Vision Books)

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