Importance of Volume in Technical Analysis Explained

Volume And Price Relations

There are two different category of players in stock market. One with smart money typically Institutional Investor or big traders having lots of information and access to quality analysis including fundamental analysis, understanding of macro economics and perhaps insider information also, and second one being general public.

Typically after a prolonged side ways market or recession, smart investors exits stocks to invest in more profitable venture, while the general public holds to it in anticipation to recover loss or to minimize loss. When market conditions begins to change, smart money starts pouring in and general public who have lost hope starts to sell and this happened gradually without much affecting the price. This phase is called accumulation where smart money starts accumulating and a next market cycle begins.

As a result of this volume activity keeps on rising till it becomes known to next level of informed traders . they Then jump into and and as a result both the price and volume moves higher. This begins phase of higher highs.

Viewing this general public jumps into the market taking it to even higher highs, to a point beyond fair value. At this phase, smart money starts moving out causing price to dip thereby forming some intermittent lows. General public sees this as an opportunity to buy on dips and starts investing more causing further highs. At this stage smart money starts to pull out gradually resulting in higher price with lower volumes. This phase is called distribution.

On analyzing this pattern one can see three things as shown in the Figure

1.Phase 1- Volume precedes price
As we have seen in phase I volume starts to increase before price actually starts moving. This gives and indication of imminent price rise. It is a bullish signal with huge reward but may require weeks to months of holding.

2.Phase 2- Volume confirms price trend
In phase II when more smart investors joins the bandwagon, Both price and volume starts to rise. At this stage uptrending is well supported by volume there by giving stamp of approval to the trend. This is highly bullish phase with quicker reward.

3.Phase III - Volume divergence leads to trend reversal.
Phase III, a distribution phase where smart money is out, volume starts to decrease and thereby giving price volume divergence. This leads to trend reversal. This is bearish phase and immediate and sharp downtrending is imminent.

Other related Links- MFI, OBV, CMF, Price volume trend, Market cycle, ADL, Trend.

We have deliberately kept this article a simple for novice traders to illustrate price volume correlation with some insight to accumulation/distribution. A detailed article containing Elliot waves will be coming soon.

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