I’m about to go out for a while, but I thought I’d leave you with a quick thought. Maybe everyone knows this, and maybe not. It’s conventional wisdom that you want to see low-volume pullbacks on trends. They are safer to jump into. Do you know why? If not, think about and make a guess before reading on. Or don’t; I don’t really care. I just like to say that stuff because it makes me sound more educational.
Ready? Let’s take an uptrend, for our example. So, you start with move up in the stock price. There are two ways this can happen (I’m oversimplifying): strong buyers, or weak sellers. You want the up move to be on high volume, because that indicates that it’s likely that you have strong buyers.
Now, the pullback. The stock price is moving down (or at least, not moving up anymore). There are two ways this can happen: strong sellers or weak buyers. Low volume during the pullback makes it more likely that you have weak buyers. And, when you think about it, that’s the preferable option if you hope that the trend will resume. This is also why you want the pullback to be relatively shallow: you want the buyers to be resting… not absent!
An “ideal” uptrend has surges of buying pressure with rests in between, and no big surges of selling pressure. In fact, books on chart patterns sometimes say that a prolonged increase in volume often indicates the end of an uptrend. I imagine one reason could be that sellers step up and eat through the remaining buyers, causing a glut of volume at the top. Another reason would be if the volume surge corresponded to a parabolic move up, which is unsustainable in most cases. Yet another reason would be that a glut of volume means a lot of people are holding shares, and the market always tries to screw over as many people as possible.
Think of that last reason for a minute, and realize why increasing volume does not point to the end of a down trend as reliably as it indicates the end of an uptrend. A prolonged increase in volume means a lot of people are long the stock. For the market to screw over the most people, it would need to continue dropping a bit longer, and then snap back up on lower volume.
So, there. I think it helps me a lot to have an understanding of what might be going on “inside” the chart. I prefer to think I’m trading real market phenomena, and not just chart patterns.
July 30th, 2007 at 8:26 am
Good explanation Richard. I think last week’s volume was an indication of just how many “buy the dippers” there were.
July 30th, 2007 at 9:24 pm
Richard,
Why does the market want to screw as many people as possible? The market is not sentient or malicious, so why do you say that? It is probably true that this is the state of the markets (the mass-screwing, that is), and it is probably a byproduct of the market structure and the mindset of the participants. Do you have any explanation for why this is the case?
July 30th, 2007 at 10:11 pm
An excellent question, and I’m not sure I have an iron-clad explanation. I think the short answer is good old reliable greed and fear.
So, let’s apply that idea to an uptrend, and you can see how it might work:
So, price should always travel fairly smoothly to and from points of equilibrium between buyers and sellers. But, markets act a lot more chaotic than that in reality. As the price gets farther from equilibrium, smart selling should be increasing. So, it takes more and more greedy excited buyers to keep it going up. (If the buying had trailed off, the move wouldn’t have continued, and there’d be no imbalance to create a reversal)
This means that when price finally does snap back to equilibrium, there tends to be more buyers trapped close to the top of the move than the bottom of the move. The relatively few smart players were done buying long ago, and maybe have even sold by now.
Shortly after this, when the reversal becomes obvious to everyone, panic causes _that_ move to be overdone, forcing more people out of the trade than would otherwise need to get out.
So, greed got them in late, and fear took them out early. You can apply these ideas and come up with scenarios for most market situations (like in the downtrend case, ignoring short sellers, greed kept them in too long, and fear got them out at the bottom. The so called big capitulation volume is the majority getting screwed as the smart money buys up their shares at bargain prices)
July 30th, 2007 at 10:13 pm
yeah, it’s not accurate to say the markets “want” to do anything… that was just me being sloppy.
July 31st, 2007 at 3:06 pm
Nice explanation, I’ll buy that.