Today, James from FreeTradePicks.com has put together a compelling article about how you can use volume to improve your trades. After you read it, he invites you to register for the FreeTradePicks.com newsletter to receive all of his updates.
For those of you who think the market does not drop hints about its next direction, don't be so sure. While the major indices do not send explicit telegrams as to their intent, some subtle clues can be gleaned if you just know where to look. We have found that careful study of breadth and depth is quite effective at spotting looming trend reversals.
What are depth and breadth? That is the brief way of describing the market's overall volume, and the number of advancing stocks versus the number of declining stocks (respectively). The former attests to the conviction (or lack thereof) of the market's moves, while the latter indicates whether or not the majority of the market's stocks are actually participating in the trends. Both are clearly requirements if a trend is to have longevity, but our analysis has a bit of a twist to it... to take the opinion and interpretation out of the equation.
Though breadth and depth data exists for the market at large, you will usually find the data in exchange-specific versions (NYSE, AMEX, or NASDAQ). Our preference is for the NYSE's data, though the NASDAQ's has back-tested successfully too.
The technique actually requires four data sets: bullish volume, bearish volume, the number of advancers, and the number of decliners for every single day in a timeframe. However, we don't use any of the raw data itself. We can't -- it is too erratic.
Rather, we use moving averages of the daily value for all four figures. This smoothes the data out into an indicator that's easy to use and interpret. More specifically, the moving averages highlight the trend of these four pieces of information. (Sorry, our moving average lengths are proprietary, but with a little experimentation, you should be able to figure out lengths that work well.)
What we're looking for are the points where the moving average of the two volume moving averages cross each other, as that generally pinpoints a switch in the market's overall volume trend; when the bearish volume average crosses above the bullish volume average, it's time to turn bearish.
In the same vein, when the moving averages of the advancers and the decliners cross one another, that too indicates a major shift in the market's underlying health.
The interpretation is the same for both bullish and bearish scenarios…crossovers of the moving averages also serve as signals.
Clear as mud? Don't worry, the graph below will clarify the idea for you.
What you're seeing is the S&P 500 in comparison to its breadth and depth data. As was mentioned a moment ago, we don't actually consider the raw daily data, since it's just too volatile to interpret. Rather, in the middle of the chart we've overlaid the moving average of the NYSE's decliners (red) on the same plot as the moving average of the advancers (green) for the NYSE. At the bottom of the chart we've overlaid a moving average of the NYSE's bearish volume (red) on the same plot as the moving average of the bullish volume (green) for the NYSE.
The "signals" occur when either or both sets of moving averages give us a crossover. Though we have pointed out two specific ones on the chart, there are actually several. Yes, some are errant; most are accurate though.
Simple to the point of being ridiculous? We can't argue that. On the other hand, it's a stunningly effective method at spotting reversals. And here's the really cool part -- it's not a coincidental or a lagging indictor... it's quite predictive.
When we fast forward to today, we can see something that most traders may not believe -- bullish breadth and depth. The market isn't just 'drifting higher' -- buyers really are flowing in, at least according to the trends indicated by both sets of moving averages. Obviously things change over time, but for right now the broad rally is actually something you can believe in. Nobody's more surprised than us, but we're not going to do an undisciplined thing like ignore the data that's right far more often than it's wrong.
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