Volume Spike Analysis by Vince Knott, CMT, CAIA
Just about every trader uses volume. How can you use it?
There are many ways to use technical analysis to generate profitable trades with enticing risk/reward ratios. However, the sellers of technical analysis–based products often exaggerate the power of simple technical tools. To succeed as a trader, you must not only apply your methods properly but also use your technical tools in a different way than others do. In this article, you will discover a new method for analyzing volume and how it can be applied to a trading strategy to be used on multiple time frames.
Volume is one of the most important tools in trading. Every type of market participant, whether trader or investor, uses volume. Volume shows how many shares of a stock have been traded in a given period of time. Price bars with high volume are more informative than those with low volume. Many patterns emerge out of volume bars, and many technical tools are also derived from volume.
One important factor in generating a good risk/reward ratio is trading the right stocks. You want to trade stocks that are active. It is generally accepted amid technicians that an increase in volume leads to an increase in volatility.
Filtering your stocks to trade only the ones with a recent increase in volume will help you find better trading candidates. Finding stocks that are about to make large moves is at the essence of a great risk/reward ratio. Once you have found the proper stocks, how do you use volume to evaluate your entries? Let’s go over some of the ways traders deal with volume analysis:
Technically derived volume indicators: One of the more popular ways of looking at volume is through technically derived volume indicators. A popular one is the on-balance volume (OBV). OBV is a running total of positive and negative volume. You can judge whether volume is flowing into or out of a stock. This indicator appears on your chart in a similar way as the relative strength index (RSI). You can see an example of the OBV applied to a price chart of Intuitive Surgical Inc. (ISRG) in Figure 1. One way that traders use OBV is to identify divergences and anticipate reversals. A downfall of this indicator is that large volume spikes can throw off the indicator in the near term.