All too often, investors get caught looking at nothing other than the price of a stock or an index and maybe a few fundamental factors. Price is king in the financial media. We can see minute-by-minute updates of the price of the Dow Jones Industrial Average and the S&P 500 on CNBC and FOX Business and we get reports on the news each night and in the papers each morning telling us exactly how much the Dow and the S&P 500 rose or fell during the previous trading period. Price is easy to report, it’s unbiased. Unfortunately, everybody seems to leave out one key piece of information—volume.
[VIDEO] Confirming Support and Resistance with Volume
Everybody seems to want to know what price a stock or index is at, but nobody ever asks what was happening at those price levels. Actually, professional traders stay on top of volume data pretty well. Individual investors, on the other hand, rarely pay much attention, which is too bad because volume can tell you a lot about which price levels are important and which ones are not.
Imagine you are an airline pilot, and you are trying to plan your flight from New York to Los Angeles. You know the distance between the two cities via the route you need to fly, and you know the cruising speed you will be able to maintain once you get going. Knowing those two things—the distance you need to travel and the speed at which you can travel—you should be able to determine how long it is going to take you to get from New York to Los Angeles, right? Well…not quite. Flying east to west across the United States, planes usually encounter a fair amount of headwind. Headwinds slow the progress of the plane, and if you don’t account for them, you will miscalculate the time it is going to take you to arrive at your destination.
Just as a pilot can choose to only look at distance and speed, you can choose to only look at price and fundamentals if you want. If you do, just remember that you may not be accounting for headwind.
While volume doesn’t slow down the price of a stock or index, it can tell you when a particular price level is significant or not.
Watching Volume for Confirmation
Volume can confirm price movements. If you can look at something at see that it looks like a duck, that is great. But if you can also hear that it quacks like a duck, you are far more certain that it is a duck. For instance, if you see the price of a stock drop down to a certain price level and then turn around and bounce back up off of that level, you may be thinking that price level is a support level for that stock. While that may be a good analysis so far, if you could look at volume and get a confirmation of your analysis that the price level you are looking at is actually support, you would be much better off.
Typically, the following characteristics of volume are true:
signifies support for a particular price movement
signifies lack of support for a particular price movement
Let’s take a look at an example to help us better understand what we can learn from volume when we combine it with our price analysis.
Volume Showing 8,000 is Solid Support for the Dow
Everybody seems to be watching the Dow Jones Industrial Average. It has dipped below 8,000 twice during the past month or so, and investors are wondering if the support level at 8,000 is going to hold. Looking at the price action of the Dow Jones Industrial Average gives us a pretty good indication that the 8,000 level should hold up well as support because, as you can see on the chart below, the Dow has been at, or just above, 8,000 for a while as the index has started to channel sideways.
Okay, so we’re pretty confident in the support level at 8,000, but what can we learn from volume in the stock market at this point. In the chart below, I have overlaid the trading volume on the New York Stock Exchange (NYSE) onto the chart of the Dow Jones Industrial Average. Looking at the two days on which the Dow dropped below 8,000—October 10, 2008 and November 13, 2008—you can see that volume spiked. This is no coincidence. What we learn from volume here is that when investors saw the Dow Jones Industrial Average drop below 8,000, they saw it as a buying opportunity for stocks and rushed in to buy. This increased buying pushed the Dow safely back up over 8,000. The best part is that we have seen it happen twice. This tells us that investors have set 8,000 as a mental buy point and that 8,000 should hold up as a significant price support level.
Volume Also Showing the Dow will Remain Flat
We can also learn something else about the Dow Jones Industrial Average by looking at volume. We can see that the Dow is most likely going to be channeling sideways between 8,000 and 9,500 for a while now. How do we know? First, we have already established that 8,000 looks like a strong support level. Second, as we watched the Dow move back up toward 9,500, an interesting thing happened. Volume started to decline. Anytime we see declining volume during an up trend, we know that the energy behind that up trend is small and that there are not a lot of investors who support the up trend.
Seeing strong volume when the Dow Jones Industrial Average was hitting support at 8,000 and weaker and weaker volume as the Dow approached 9,500 tells me that 8,000 is a good support level and 9,500 is a good resistance level, and the Dow will most likely move back and forth in this range for a while—barring any unforseen cataclysmic news.