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VOLUME
SHOULD EXPAND ON BREAKOUTS
In last week's "Inside The Black Box" section I discussed
three principles of volume that are important to profitable swing
trading. The first is the idea that volume should expand in the
direction of the trend.
Next, we noted that price patterns should not be viewed in isolation. A
novice technician may spot a "seeming" price pattern, such as
a head and shoulders, and may conclude that because the pattern has the
correct shape the price formation has been "nailed." More
experienced technicians, however, are aware that the price pattern must
correlate with a volume pattern in order to validate the formation.
Finally, we saw how very high volume at a specific price level can be
used to estimate the length of time a stock may take to overcome support
or resistance when it is next encountered.
For me, perhaps the most important use of volume is to ascertain the
validity of a breakout from a price pattern. When price breaks out of a
pattern such as an ascending triangle, there are two possibilities -- it
can do it on well-above-normal-volume, or volume can be average (or
perhaps even lighter than normal).
The most powerful breakouts are always
accomplished on much stronger-than-normal volume. Heavy
volume on the breakout shows that buyers are willing to bid the price
up. In general, they are willing to buy at the ask price rather than
fight to be filled at the bid price since they are confident that the
share price will eventually move higher.
But what defines "heavier-than-normal" volume? There is no
exact statistical answer to this question. The principle is the
higher above normal volume the breakout occurs on, the stronger the
technical situation. When visually examining the volume
histogram below the price chart, the higher the volume bar towers above
bars of the immediately proceeding period on the day of the breakout,
the more likely that shares will move significantly higher in the coming
days.
A second way to see the strength of the breakout is to look at the
average daily volume line. I reproduce the charts in this newsletter
from www.stockcharts.com -- an excellent resource that shows a 60-period
exponentially smoothed moving average of volume. On a breakout, when
bars are well above the moving average, intense eagerness on the part of
buyers is shown. If they are equal to or below the moving average bars
when price breaks out, then the breakout is suspect. It is likely then
that prices will move slightly beyond the breakout level and then
retreat. If a swing trader buys a breakout of this type, then it is
generally wise to place a stop loss immediately below the breakout
level. This way, if price retreats below what should be support, then he
or she will not get trapped in a losing position.
When I teach technical analysis courses, students will often press me
for a definition of heavy volume. My standard reply is "at least
50% greater than the 60-day moving average." However, a very strong
breakout may see activity that is three or four times that amount.
In March of this year I recommended a swing trade on OmniVision (OVTI,
$44.26) just as it completed a breakout from a four-month ascending
triangle pattern. On the day of the trade recommendation, the stock had
climbed above critical round-number resistance at $20. I've circled the
volume bar from that day in the chart below.
On the breakout OVTI traded almost 4 million shares. That figure was
well above the 60-period moving average, which up to that time stood at
1.2 million shares. The completion of the ascending triangle occurred on
a bit over three times normal daily volume. As you can probably guess,
the stock then hit our price target in less than a week, resulting in a
better than +13.6% gain. (The shares have not looked back since, more
than doubling in price since we made the recommendation.)
For an interesting contrast to OmniVision, take a look at the chart of
Alliant Techsystems (ATK, $50.94). I have selected a period between
March and late July of 2003 in which ATK, like OVTI, also formed the
same price pattern over the same length of time: a four-month
ascending triangle pattern. The chart ends the day of the price
breakout. If you only examine the price chart, then the situation looks
very bullish, doesn't it? After stalling on many different occasions at
$55, ATK finally closed above this level for the first time in four
months.
But what about volume? Note that the volume bar on the day of the
breakout was just barely able to make it above the 60-day period moving
average line. Average daily volume was 345,000 for the last 60 days, and
on the day of the breakout it expanded only to 422,000. Volume on the
day of the breakout was only 22% above "normal." Clearly a few
buyers moved into the stock, pushing it higher. However, the breakout in
price without the confirmation of volume was not to be trusted.
Now for the rest of the story. Below you will find a chart of ATK from
the time of the breakout to the present. Notice how prices stalled at
the breakout level for several days and then began to fall rapidly. A
true high-volume day occurred on Thursday, August 21st when ATK went
from above $52 to an intraday low of $49 and did so on nearly 2 million
shares -- approximately five times the normal daily volume. (This spike
low appears to be a short-term selling climax, a topic I will cover in a
future "Inside The Black Box" article.)
The lesson of OVTI versus ATK is that breakouts from multi-month
consolidations should occur on well-above-normal volume in order to be
trustworthy. The swing trader must analyze not only the price pattern,
but must also pay an equal amount of attention to volume. It can be
seductive to focus only on price, but the cost of this temptation is
often high.
Next week, I will discuss the volume pattern when a stock breaks down
from a support level.
Good trading!
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