Monday, March 08, 2010

The Importance of Relative Volume: Is It a Slow Day or a Go Day?

I received an email from a trader who lost a good amount of money today trading the stock indexes. He was particularly frustrated because the money was lost during a day when there was little overall movement and opportunity. Indeed, the daily range in SPY today was only about .39% on volume that was one of the lowest for 2010.

The trader's problem was that he identified the limited opportunity set only after he had lost his money. Instead of first identifying the day's likely level of opportunity and trading accordingly, he placed his capital at risk--only to discover the lack of opportunity.

One of the most valuable tools for identifying opportunity is relative volume. Seeing how today's volume compares to recent volume at that same time of day provides a perspective on how much institutional participation is in the marketplace. Markets need that participation in order to move: volume is the source of market energy. Without the energy of market volume, stocks may move higher or lower, but those moves are likely to be muted in magnitude.

Going back to 2009 in SPY, we find that daily volume correlates with daily trading range by a whopping .85. That means that over 70% of all variance in market movement (range) is accounted for by shifts in market volume.

By tracking how early volume compares to average volume early in the day, we can begin to get a proactive read on likely levels of market movement. The key to successful trading is not just scouring for market setups. The key is first asking whether markets are moving enough to justify trading those setups.