Tuesday, May 27, 2008

Why Volume Matters: Reading the Market's Real-Time Auction Process

If you click on the chart, you'll see today's afternoon trade in the ES futures with price displayed in one-minute candlesticks and volume below. You can see that we traded in a range for over a half-hour and then broke higher at 13:36 PM CT. As the pink arrow indicates, that breakout occurred on increased volume. We then contracted in volume on a brief consolidation of that burst upward before resuming the upward course on even greater volume.

After a solid rally, prices consolidated for about 40 minutes, but notice how volume dried up during the consolidation. We then traded higher and, again, volume expanded on the rise.

Recall that volume is significantly correlated with volatility. When volume expands in the direction of the trade, it means that you have a correlation of volatility and direction: those are the sweet spots that will give you your best short-term moves. When volume contracts as the trade moves against you, it suggests that volatility is not moving against you, and it can make good sense to stay in that trade.

Volume expands because of the presence of large traders; it is not a sudden influx of small, retail traders creating a doubling or more of volume during a time period. Rather, institutional traders are attracted to the new price highs--and help keep the move continuing in the short run. When volume expands in the direction of the market, it means that the new prices are attracting market participation. There is acceptance of value at these new prices. It is out of such dynamics that trending moves are born.

Good breakout moves will feature an expansion of volume on the move out of the prior trading range, a pullback in volume during any subsequent consolidation, followed by further trending price action on expanded volume. The pullbacks on reduced volume represent opportunities to enter the trade in the direction of the trend.

Just knowing whether you're making new highs or lows isn't enough: you want to see how the market's auction process is accepting and facilitating trade at those fresh price levels. Volume is one important key to reading the market's real time auction. The link below (and the links within that post) will provide further background on this important facet of trading.


Tracking the Market's Large Traders


ak said...

Volume expands because of the presence of large traders; it is not a sudden influx of small, retail traders creating a doubling or more of volume during a time period.

That gives me an idea. Which new opportunities could a distributed network of small traders create by collaborating (for example, synchronous buying)? This could democratize trading and serve as a check against strongarm tactics by large participants. There is the issue of trust, but that problem can also be tackled in the Web 2.0 world.

jeff said...

dear Dr. Brett, today (Friday) has been the second day in a row that this observation and explanation of yours has been making me money (yesterday ant 1 pm est and today at around 11:30 AM EST). Thank you!!

duke.glosgow said...

Well said Doctor. It makes a lot of sense i always knew that profit is directly propotional to Volume. However this is the best way it could have been put forward.
Duke Glasgow
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