Monday, February 26, 2007

Tracking the Dollar Volume Flows of Stocks

Over the weekend, I've been working on some fascinating research to answer a group of questions: How much money is actually flowing into or out of a particular stock on a given session? Are these dollar volume flows increasing or decreasing over time? Is the stock attracting more dollars than other stocks in the same sector? Than stocks in other sectors? And--most important of all--how is the amount of dollars flowing into a stock related to how that stock behaves going forward?

As I indicate in my latest Trader Performance entry, Relative Dollar Volume Flow appears to be a promising measure of underlying demand or supply for a stock. The idea is simple: take every trade that occurs in a stock during the day and multiply the price at which the trade was transacted by the volume of that trade. If the trade occurred on an uptick (or if the last price change was an uptick), you add this value to a running cumulative total for the day. If the trade occurred on a downtick (or if the last price change was a downtick), you subtract this value from the running cumulative total for the day. At the end of the day, the final cumulative total reflects the buying or selling of large market participants (institutions that transact large blocks, large portfolio managers), because their transactions account for most of total (given the large volume of their purchases or sales).

If you have institutions eager to get into a stock, they will buy large positions on upticks. If those institutions are eager to bail out of a stock, they will sell large positions on downticks. The logic is similar to Market Delta, only this is a measure intended for longer-term analysis. (It would be interesting to study it on an intraday basis for signals, but so far I have not done so).

I refer to this as *Relative* Dollar Volume Flow because I divide the cumulative total at the end of the day by that day's trading volume. This provides a better comparison of the money flowing into one stock vs. another: One million dollars flowing into a large cap stock that is an institutional favorite will reflect lower Relative Dollar Volume Flow than one million dollars flowing into a lightly traded small cap issue.

One application of Relative Dollar Volume Flow is to ETFs. Does the amount of money flowing into or out of an ETF tell us anything about the Fund's performance going forward?

I conducted a small investigation of the Dow Jones Industrial Average ETF (DIA) by tracking its daily Relative Dollar Volume Flow from the beginning of 2004 to the present (N = 771 trading days). When the 20 day Flow for DIA was positive (net money flowing into DIA; N = 442), the next 20 days in DIA averaged a gain of only .05% (245 up, 197 down). When the 20 day Flow was negative (net money flowing out of DIA; N = 329), the next 20 days in DIA averaged a very solid gain of 1.11% (227 up, 102 down). This is a pronounced reversal effect: when we see money flowing out of DIA over a 20-day period, returns have been superior. When DIA has attracted dollars over a 20-day period, returns have been subnormal.

Very interestingly, if we calculate the Dollar Volume Flow for the Dow by individually summing up the Flows for the 30 component stocks, this value correlates with the Flow for DIA by only .14. In other words, money flowing into and out of DIA is not especially reflective of money flowing in and out of the individual Dow stocks. Rather, DIA's flows (like those of other index ETFs) may be more skewed by the activity of hedgers and program traders who might not be making long-term portfolio adjustments.

Indeed, the Dollar Volume Flows for the summed 30 Dow stocks shows that money has been continuously flowing into those issues through the bull market and really accelerated after we made a bottom in July of 2006. Although there are individual issues with net dollar outflows (MSFT is notable in that regard), there is little evidence at present that money is systematically flowing out of the Dow. (Inflows have slowed over the last two weeks, but remain positive).

An especially promising strategy is to identify stocks with favorable expectations based on their Relative Dollar Volume Flows and those with subnormal expectations and create a long/short strategy of buying the former and selling the latter. This would create a diversified portfolio that would be relatively market neutral. I'm also beginning to take a look at falling stocks with rising Dollar Volume Flows and rising stocks with weakening flows to see if we can anticipate turns in those issues. Clearly, there's a lot of room for interesting research here. I hope to report results in the near future.

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