In a recent post, we saw how stock market volume correlates quite highly with next day volatility. This, along with our understanding of options volatility, helps us anticipate the magnitude of movement likely in the day ahead. In this post, we'll take a look at how volume affects the odds of hitting particular price targets.
Once again, we'll use relative volume--how today's volume compares with the median 20-day volume--as our basis for analysis. We'll go back to 1996 in the S&P 500 Index (N = 2935 trading days) and examine what happens when we have above average relative volume (N = 1519) and below average relative volume (N = 1416).
When today's volume exceeds the 20-day median, we had an inside day (today's high lower than yesterday's high; today's low above yesterday's low) only 127 times in 1519 days, or about 8% of the time. When today's volume is below the 20-day median, we had an inside day 246 times in 1416 days, or about 17% of the time. We're thus twice as likely to have an inside day on slow days as busy ones. Stated otherwise, when volume is above average, we've hit yesterday's high or low price 92% of the time.
Conversely, when today's volume has exceeded the 20-day median, we've had an outside day (today's high greater than yesterday's high; today's low below yesterday's low) 212 times in 1519 days, or about 14% of the time. When, however, volume has been below the 20-day median, we've had an outside day only 107 times in 1416 occasions, or a little over 7% of the time. Thus we're twice as likely to have an outside day when the market is busy than when the market is slow and 93% of all slow markets won't be outside days.
Interestingly, whether the market is busy or slow does not significantly affect the odds of hitting yesterday's pivot level, which is defined as the average of the high, low, and closing prices. When relative volume is in the top quartile of its distribution, we see a slightly lower set of odds of hitting the prior day's pivot level, but this is not meaningful. Overall, we average hitting the prior day's pivot about 2/3 of the time.
Now let's look at the odds of hitting the R1 and S1 resistance and support levels, derived from the prior day's pivot price. (See my previous post for details on the calculation of R1 and S1). When volume has been above the 20-day median, we've hit either the R1 or S1 level 1328 out of 1519 times or close to 90% of the time. In a busy market, then, it makes sense to not just use the prior day's high or low as a price target, but R1 or S1. When volume has been below the 20-day median, we've hit the R1 or S1 level 1170 out of 1416 times, or about 80% of the time--still a hefty percentage.
When relative volume has been 30% or more ahead of the 20-day median (N = 722), we've hit either R1 or S1 642 times, again about 90% of the time. When relative volume has been 30% or more below the 20-day median (N = 425), we've hit R1 or S1 288 times, about 70% of the time. Thus, there are overwhelming odds of hitting R1 or S1 when markets are relatively busy and somewhat reduced, but still favorable, odds when markets are slow. Overall, it makes sense to look to R1 and S1 as initial price targets, particularly in busy markets.
Now for one last look: Let's examine what happens when today's raw volume in SPY exceeds yesterday's volume (N = 1457). When today is busier than yesterday, we hit either the R1 or S1 levels on 1350 occasions or over 90% of the time. When today is slower than yesterday (N = 1478), we hit these levels on 1036 occasions, or about 70% of the time. When today's volume exceeds yesterday's volume by 30% or more (N = 745), we hit R1 or S1 a whopping 713 times--about 95% of the time. When today's volume falls short of yesterday's volume by 30% or more (N = 496), we only hit R1 or S1 on 279 occasions, about 55% of the time.
Again, we see that, the busier the market, the more likely we are to hit price targets derived from the prior day's pivot data. This makes sense, since the R1 and S1 targets are derived from the prior day's range. If today's volume exceeds yesterday's, on average we'll have a larger range and thus will trade through those targets.
Of course, none of this is predicting directionality. We're simply using volume to investigate the likelihood that moves to certain targets will occur. Given that volume correlates with volatility, it makes sense that markets would be somewhat more likely to hit targets (prior day high or low; R1 or S1) when they're busiest.
In my next posts in this series, we'll start to look at handicapping market direction.
What Every Short-Term Trader Should Know About Volume