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CLIMACTIC
DOWNSIDE VOLUME AND SWING TRADING OPPORTUNITY
In the past several StreetAuthority
Swing Trader issues we've dedicated this "INSIDE
THE BLACK BOX" section to the exploration of several volume
principles essential to correct chart interpretation. By taking volume
patterns into consideration before making any trading decision, you'll
be much more likely to uncover highly profitable swing trades.
Here's a quick look at some of the volume principles we've already
discussed:
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Price patterns must always be looked at in
conjunction with their associated volume pattern, never alone.
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Careful analysis of the volume of selling that
occurred above current resistance will help you estimate how long a
stock will stall at that level.
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Well-above-normal volume is essential when
separating a true from a false breakout above resistance.
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Well-above-normal volume on the break of a key
support level is likely to keep the swing trader from making the
mistake of shorting into a deceptive "spring" formation.
This week I want to talk about climactic downside volume
and how its retest creates a profitable swing trading set-up. Climactic
downside volume will typically occur after one of two circumstances.
First, if a stock is in an extended downtrend, then a washout day of
very heavy selling may accompany a new low. Second, unexpected news such
as a negative earnings pre-announcement or issue of corporate misconduct
can create an enormous volume spike. In these cases, institutions are
apt to sell first and ask questions later.
Swing traders should be aware that a trend will often reverse, at
least temporarily, on a burst of enormous volume. The volume burst
signifies that many of the sellers have already gone through the exit
door. There is no place for the stock to go, at least in the short term,
but up.
The upside reversal off a climactic selling volume spike, while it can
be swing traded, requires both patience and a great deal of nimbleness.
Residual sellers who have not yet hit the panic button often see this first
rally off the bottom as a chance to recoup some of their losses.
With this in mind, the first advance off the low is often grudging as
the stock runs into selling pressure or resistance.
Eventually, then, a retest of this first low can occur. That second
bottom, when you spot it, should be scrutinized very carefully. If
volume on the second bottom is far lower than at the selling climax,
then the stock has likely found a key support level. If this is the
case, then at this point the shares will more often than not reverse off
this important support. The nearby support allows traders to set fairly
tight stop losses as well.
To confirm this reversal off support you'll want to examine a good
combination of indicators. I generally use stochastics and MACD.
Stochastics is typically the more rapid indicator and will give the
first signal of trend change. If MACD then confirms this signal with a
buy signal of its own, then the probability of a tradeable rally is
high.
Below is a chart of mortgage lending giant Freddie Mac (FRE). In early
June the stock gapped sharply lower, trading almost 60 million shares in
a single day (approximately 12X the normal daily volume). Three trading
days later, FRE was still trading 40 million shares, as the stock hit
bottom just below $47.50. It then commenced a rally that took it back to
the bottom of the gap at $55 in early July.
FRE then sold off steadily into early August, again
testing the $47.50 level on the first trading day of the month. On this
retest, however, trading volume was extremely subdued. In fact, it was
under the average daily volume for the period. Such a low-volume retest
is a valuable clue that an important reversal could be
happening. More evidence should be sought, however, that a turning
point has been reached. In this case, FRE gave that evidence.
There were four important clues that a rally was about to occur. First,
the stock made its second low with bullish divergence between price and
both the MACD histogram and MACD. Bullish divergence occurs when price
hits an equal or lower low, yet the indicator moves higher. Second, the
stock broke a three-week Intermediate downtrend line two trading days
later. Third, stochastics then gave a buy signal and MACD confirmed this
signal very shortly thereafter. Ultimately, FRE then rallied back to
resistance at the top of the gap.
A low-volume retest of climactic volume sets up the distinct possibility
of a reversal rally. When running visual scans of stocks, look for this
pattern. Put them on your watch list. If indicators such as stochastics
and MACD give buy signals, then you have found a low-risk (and
potentially highly profitable) swing trading opportunity.
Good trading!
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