While it may seem technical analysts are fond of analyzing and interpreting only price patterns. The majority of technical trading rules consider both price shifts and shifts in the corresponding trading volumes. It only makes sense to see a confirmation of a trading rule in actual buying and selling of a security in sufficient volumes.
The Dow Theory
Most technicians would agree that discussions concerning price and volume data should start with the Dow Theory. If for no other reason, then the Dow Theory was among the first theories developed on the subject that has also persisted to this day.
In very general terms, note that the Dow Theory postulates the existence of three basic types of price movements over a certain period of time, including;
- Significant trends resembling tides in the ocean
- Intermediate trends resembling waves, and
- Short-run patterns resembling ripples.
Proponents of the Dow Theory have spent considerable time identifying major “tides,” while also finding ways to deal with intermediate “waves” and short-term “ripples.”
Significance of Trading Volumes
Technicians watch for shifts in trading volumes just as much as they watch for shifts in price movements. Why? Simply, changes in volume and prices are indicative of changes in supply and demand. In other words, if the value of an index, for example, changes in one direction, it does not necessarily mean that the breadth of the market is also shifting in that same direction.
For example, if an index increase on heavy volume, this is typically considered a bullish signal. Alternatively, if an index decreases, also on heavy volume, this is generally considered a bearish signal.
There is also a ratio of upside/downside volume, whereby every trading day, stocks listed on a major exchange that have experienced heavier trading are divided by stocks that have experienced lighter trading, compared to their normal levels.
These statistics are published daily in The Wall Street Journal, and weekly in Barron’s, and are often used to gauge market momentum.
Support and Resistance Levels
A support level is established in the price range when a technician would expect a considerable increase in the demand for a stock. Historical data indicates that stocks usually hit the support level after a prior substantial price appreciation, and the subsequent profit taking have been exhausted.
A resistance level is established in the price range at which a technician would expect to see an oversupply of a stock and the resulting price reversal. In some ways, think of the resistance level as if the stock has hit the “glass ceiling.”
Although there might be some buying pressures from speculators, nervous investors who bought in at a peak tend to overhang the market by trying to break even.
Technical analysts believe that once a trend has reached sustainable velocity, it will continue developing in the same direction until there is a significant event to curb the momentum.
Technicians also believe that these momentums have measurable strength, which can be computed from weekly or monthly price/volume data to arrive at relative strength ratios.
If the relative strength ratio increases over a measurable period of time, it demonstrates that a particular stock or industry is outperforming the rest of the market. Most technical analysts would also expect this trend to continue.
Technical analysts have found the relative strength ratios to work both in rising and declining markets. For example, if a stock or industry goes through a period of underperforming the overall market, the relative strength ratio will still continue to rise.
This is simply indicating that the downtrend of the underlying security or industry is likely to continue, too.
Charts are perhaps technical analysts’ favorite tools. There are bar charts, which plot daily, weekly, or monthly highs and lows in a vertical manner to form a bar. Often a horizontally plotting line is used to indicate the trend of closing prices.
Note that almost all price bar charts also include volume bars for easier trend confirmation.
There are also multiple indicator charts, which combine several indicators along with price and volume data, such as 50-day and 200-day moving averages, the relative strength ratios, etc.
Finally, another popular chart type is a point-and-figure chart, which, unlike a bar chart, plots only significant price shifts, disregarding their timing. Technicians then award these shifts one, two, three, points, and so on, to record considerable price intervals and determine the potential for price reversals.
Since point-and-figure charts record only significant price movements, many technical analysts find them more comfortable to use and more illustrative of the overall price movements.