Years ago technicians would compare total volume on the New York Stock Exchange to that on the American Exchange. The thinking was that the traders and the issues on the AMEX were more speculative in nature than those stocks on the New York Stock Exchange. Therefore by comparing the two exchanges’ vol- umes and expressing it in terms of percentages, we could gauge the level of risk the market was able to handle. If the index would get too high, the indicator would be flashing a warning sign that there is too much speculation. If the numbers were low, it would suggest that there was plenty of room to move higher due to the low levels of investors willing to take a large risk. By measuring the volume levels one against the other, it was possible to estimate whether money was flowing into high- grade or low-grade issues.
Well, using those two exchanges today would be silly be- cause the two markets are not what they once were. Besides, if you want to do only what I spoke of you could use the NAS- DAQ and the NYSE. But thanks to new areas like the Ex- change Traded Funds (ETFs) and all the derivative products, we can contrast and compare all night long. The same exact concept is the goal, but now we can look at the market with a much better and stronger microscope. Today, following vol- ume and therefore finding out where the traders are most in- terested has become a much more reliable and insightful tool than we have ever had before. International markets, sectors, asset classes, and groups are all fair game and arrive at con- clusions that are many times sharper than back in the bad old days.
CONCLUSION
Volume can be a very helpful tool in trying to judge the valid- ity of a price move in a time series. The level of activity, in con- nection to price action, can add another layer of confidence to your outlook by enabling you to conclude that the action caused an increase in volume levels. Volume can also serve as a warn- ing if it fails to keep pace with price or we see too much volume with no price action. The bottom line is that this tool that we label volume can provide us with more pieces to the puzzle and needs to be a part of your tool chest if you ever expect to mas- ter technical analysis.
Momentum
O
n June 22, 2004, we witnessed the first commercial flight into space by pilot Mike Melvill, and perhaps someday we might look back on that date as historic. But that’s beside the point. When the ship was launched it was attached to a larger plane that took a slow, gradual, upward path. Once the ships were in position, Melville’s craft, SpaceShipOne, was released and fired its own rockets to propel itself into outer space. For a non-NASA flight you had to be impressed. The plane stayed at those lofty levels for about 3 minutes and started its descent back towards earth. It reached its zenith and declined to its nadir. We saw the slow advance, a rapid increase in altitude on a spiking power thrust, a stage of gradual leveling out, and finally its rapid descent.I felt that this is a perfect way to think of momentum and explain what we are trying to measure. The fact that during part of its leveling-out phase the ship was still rising is not im- portant; what is relevant is that the rate of ascent was slowing compared to the acceleration stage. That slowing of the rate of acceleration is the information that we seek. If we witnessed a slowing of forward momentum in a stock, as we did with the spaceship, we would have advance warning that the stock might be reaching an end to its rally and it might be time to take prof- its or at least be ready to act upon additional signs.
What momentum indicators measure is the speed at which price is changing rather then price change itself. The same type of thinking is used in determining the momentum of a stock or a market. What we want is to know whether the rate of ascent or decline is maintaining it’s power or losing thrust as the price picture unfolds.
OSCILLATORS
The moving average concept, which is covered in depth in the next chapter, was briefly mentioned earlier as one of the tools to be employed during a trending market. In nontrending mar- kets, however, the oscillator is the weapon of choice because it is designed to signal when the limits of a trading range have been reached. Oscillators, which are extremely useful in trading/ neutral markets, can be harmful at the beginning of a major ad- vance or decline. The signals that are generated at the outset of an important move show the market as being either over- bought or oversold. I will speak later of the differences created at these turns.
These tools are a way of examining momentum and not just a simple average of price. Oscillators are trying to give us ad- vance warning of a turn by examining the rate of change in the price action. They look at the internal power of the price by com- paring the current price with the price at a fixed period in the past, therefore warning us of market extremes.
When that rocket ship reached its highest point, it stopped climbing up, but it did not immediately drop out of the sky. It hung there in space, although it had lost its forward push and was in the process of changing direction. That’s what oscillators are trying to measure and trying to warn us about the prices.
While oscillators are very versatile, there are really only two formats for this tool. They usually appear at the bottom of a price chart and are fairly easy to interpret. Depending on the math you employ, an oscillator can be set up to have a scale of 0 to 100 or we can use a 0 line as a midpoint and plot the os- cillator above or below that 0 mark. In the case of the 0 mark- ers, we would run the numbers like this. Working with a 20- day rate of change, we simply would compare today’s price with
the price 20 days ago. If the current price is 35 and 20 days ago it was selling at a price of 30, then a plus 5 would be plotted on the grid. On the reverse side, if the price today was 5 points lower then 20 days ago, we would plot a minus 5 on the grid. By looking at the price chart and the oscillator chart, we can compare the action of both to determine if the momentum is giv- ing us the proper indications.
The other method is to show the same type of number, but in this case the scale would run in a band from 0 to 100. To judge its overbought or oversold condition we would set upper and lower parameters to gauge the extremes. (See Figure 7-1.) I mentioned earlier that moving average lines are very help- ful in trending markets. A generally declining market with a stock that is in a well-tested down channel can be money in the bank simply by “shorting” into each test of a downward-slanting moving average line. The same can be said for a strong issue in a bull market phase. However, trend-following tools during neu- tral or nontrending markets are as useful as a library card for
F I G U R E 7 - 1
your dog. At the beginning of a major move, an oscillator will become overbought or oversold very quickly and generate a false signal. The reason for these erroneous readings is that many times as we come out of a major bottom, the action on the tape will be in the form of a power thrust for both price and volume. The net result is these large increases in the market numbers will give warnings initially to the traders. At market tops, we will find the same conditions. In the early stages of a rollover, the number will signal that the market is oversold and in a pos- sible positive state, while in fact we are just starting a move lower. The way around this is to follow the other indicators, such as pattern recognition, moving averages, trend lines, etc. in com- bination with oscillators.
Oscillators, however are made for markets that are con- fined to a range and swing between the resistance and supports. These tools help us identify overbought and oversold zones and any loss of forward or declining momentum.
The velocity of price is what we are after in our measuring of a stock’s price movement. The technician is always running a price comparison for the time span he has assigned to the os- cillator. So we are looking at today’s price in comparison to an earlier time. If you construct a 20-day momentum line, for in- stance, you simply subtract the closing price of 20 days ago from the current closing price. It is then plotted around a 0 line to show a positive or negative reading. A reading that shows that the current price is lower than it was 20 days ago would regis- ter below the 0 line and have a negative implication. However, if the current price were above where it was 20 days ago, it would be above the 0 thresholds. Like many of the other indi- cators we have spoken about, remember, the shorter the time period that is used, the more signals will be generated.
A moving average is an average price history, and its sig- nals occur after the fact because we are looking at past data. Oscillators, on the other hand, are trying to give us advance warning of a turn, either up or down, by examining the rate of change in the price action. They look at the internal power of the price by comparing the current price with the price at a fixed period in the past.
Let’s try to put some realism into the oscillator. Say we have a stock that is in a strong rally mode, and day after day our 20-day oscillator is showing that the current price is ahead of the older price point. We would have the oscillator in a pow- erful uptrend until it starts getting into an overbought territory. Overbought and oversold zones are judgment calls, and we would look to the left of the chart at the history to spot past lev- els that were the upper and lower limits for the particular item we are following. One index might have very different volatil- ity characteristic than another index. These oscillators can lead price because you are comparing current to past prices and see- ing visually whether or not the price is maintaining its internal momentum. It’s our old friend supply and demand again that is being measured. Buyers make stocks rise and sellers cause them to drop. As long as the index can stay ahead of its most recent past, then upward momentum is maintained. When we see the oscillator’s line begin to roll over and start its descent, that’s when the red flags should pop up. The demand side is exhausted as the buyers are satisfied, or as a result of the rally the index has gotten so overbought that sellers became aggressive enough to stop demand.