On any time scale, volume correlates very highly with volatility. During the recent decline, for example, we traded well over 200 million shares in SPY. During the low volatility push higher prior to the decline, we commonly traded under 100 million shares. Who are these additional participants? For the most part, they are value players trying to take advantage of unusually high or low prices; short-term directional traders trying to take advantage of the movement; and longer time frame participants stopping our of positions. In short, when we see added volume, it means that the proportion of directional traders relative to market makers has increased. This facilitates market movement.
Conversely, when we see volume dry up, it means that directional traders are not perceiving opportunity in that instrument. That leads to less movement on all time scales and what short-term traders experience as "choppy".
OK, with that in mind, let's take a look at yesterday's trade in the ES futures depicted above. A number of traders who sent me their journals made money on the opening drive. They recognized that we were oversold and that volume was strong at the open, with buying significantly exceeding selling. The combination of high volume, buying interest from value participants, and short-covering from those leaning the opposite way created a momentum thrust.
An important way we can identify high volume at the open is with the measurement of relative volume. In relative volume, we take the average volume for each time of day (above we have five-minute time intervals) and see how today's volume from 9:30 AM EST to 9:35 AM EST compares with the average volume at that time of day. High relative volume tells us we have high participation from directional players. In the first three five-minute segments of the day yesterday, we had volume between 2 and 4 standard deviations above average.
Note how having the right data helps you make the right adjustment in your trading. We commonly think of psychology as helping our trading, but approaching trading the right way--with the right information--is a big part of having the right mindset.
Interestingly, a number of the traders who wrote to me and who made money in the early morning move gave back money midday. Why is that?
Click on the chart above and you'll see how volume moved meaningfully lower in the midday hours. By the time we bottomed during the 2 PM EST hour, the average five-minute volume had fallen to about one-fifth of what we saw in the opening periods. With that waning of volume, we have waning volatility: no more momentum. Traders who did not pay enough attention to volume implicitly assumed that we were still in a momentum market. Every move was taken as a potential breakout--only to reverse due to the lack of participation. The trader who paid attention to volume was able to adjust expectations and either scalp smaller moves or stand aside altogether.
When we get excited about making money, we often become tunnel-visioned and don't step back to see what volume is doing.
Even worse, when we get excited, we don't step back to observe what is happening on the larger time frame. Notice how volume is drying up as the sellers are coming in. We had quite negative NYSE TICK readings during that 2 PM EST period and yet volume was drying up. Moreover, with all that selling pressure, we couldn't retrace more than about half of the early morning move. Recognizing that larger pattern set us up for the late day continuation of the upside momentum trade as volume picked back up.
This is how psychology integrates with trading: The cognitive flexibility to shift between price action and volume and the flexibility to shift from moment-to-moment to the larger time frame complements the ability to track buying and selling pressure and its shifts. When we become self-focused and P/L focused, we lose that cognitive flexibility. We no longer trade with perspective. So much of trading success is using our psychology to detect patterns in the market's psychology.
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