Volume Confirmation

October 16, 2007 at 9:28 pm · Filed Under Educational 

The price on a stock chart is obviously vital, but many people don’t realize how important the volume is too. When trying to decipher the meaning of broken support or resistance, one of the differentiating factors is the volume. Increasing volume shows intensifying action, which is normally a confirmation in the direction of the move. Decreasing volume means the action is drying up, and often times is just a correction before the stock continues the longer term trend. To see an example of this, let’s take a look at the run up by Chesapeake Energy (CHK) during 2005.

Volume Chart

On the chart, I’ve drawn the trend and the support/resistance lines during the period of interest. At point 1, the stock broke out with higher volume, made a little channel between $24 and $26, and then continued upwards. After running into some resistance around $30, there was a sell off back down to $26. At point 2, notice how the volume was lower during the decline than it was at the push up to $30, and around the same volume as the breakout at point 1. While many longer term investors might have gotten shaken out at the bottom of point 2, recognizing the lack of volume and playing a looser stop at $26 would have rewarded them, since the stock sprung back the same day. After a week of positive days, the stock quickly got back above the trend line at point 3, where it broke out on even higher volume and ran up a little more. The next time it broke the trend line at point 4, there was massive volume confirming the decline. The astute reader may also see that there was actually a warning sign a couple weeks before that, when the stock had a large drop with greater volume than point 3 had. As I’m writing this 2 years later, the stock has yet to break $40.

When a stock is just hanging around your buy or sell points, wait for a big volume day to confirm your decision. Even though there may be a very defined pivot right at $50, a stock will often test it and hit $50.04 or $50.07, but not actually breakout. Often, after failing a few times, a stock will break down, at which point you’ll be glad you didn’t buy prematurely. Although a little harder on the sell side, look for volume confirmations (or a lack of volume) to confirm that the downwards move is just a correction. While you still need to define your cutoff point, if you believe it’s just a correction you may want to play a looser stop, giving an extra percent or two below your normal stop. It takes a lot of practice to learn how to read charts well, but knowing how to take the volume into account will have you on your way to using them effectively.

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