For short-term directional traders, opportunity often boils down to movement. It's tough to take a lot out of a market that is moving in a narrow range. This is why a common topic I hear among the traders I work with at SMB is whether they should be focusing on trading the market vs. trading individual stocks that are moving. In lower volatility market environments, it's often promising to shift the trading focus to those "stocks in play".
That is why I carefully track the relative volume in the overall market on an intraday basis. Above we can see the last two trading days in SPY (top), with five-minute bars going into the market close. The bottom panel consists of color coded relative volume bars. Relative volume tells us, at each time period, whether the volume we are currently seeing in the market is above average (green), average (blue), or below average (red) compared to the last five trading sessions.
Let's think about what that means. If we see unusually low relative volume, it means that large, directional participants are not active in the market. In relative terms, market makers and short-term traders are dominating the price action. The players we need to see in the market who can create sustained momentum and trends are not a force to be reckoned with in the market. To some degree, in today's market, that is a function of institutional participants sitting out of the market ahead of tomorrow's Fed meeting. You can see from the yellow arrow and the sequence of declining red bars that, as the day proceeded, volume was low and became even more relatively restrained.
That was important to the day's trade because we had gapped up with decent initial breadth. A trader seeing that might wonder if we would see upside momentum through the day and a possible vigorous trend day. Noting relative volume, the trader would have questioned this hypothesis, which turned out to be a good decision.
Relative volume also provides important information relevant to how much we can take out of each trade. Early in the morning, I bought a pullback in the market and, noticing the low volume, sold it for a quick four-point gain in ES. Had the strength attracted greater participation, I might have sought a more distant profit target. Low volume means, not only less movement per day, but less movement per bar.
Many problems in trading occur when traders don't properly identify and adapt to the opportunity environment. They play for momentum when the participants who create momentum are not present. They add to positions that initially go their way only to see the market reverse amidst lower volume. It isn't enough to focus on trading "setups". We need to know how the market is likely to move when conditions set up. It's yet another example of how having the right tools can help us master the craft of trading.
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