This book is about technical analysis. Moreover, it is about one particular type of technical analysis. You will not see anything about earnings, or dividends or cash flows. Nowhere will we mention management or products or competition or sales. Search all you want but you won’t find another mention of price to earnings ratios. All we are going to be concerned with is price and volume. We are going to look at the past, and try to anticipate the future, and we are going to do so without ever looking at a single fundamental factor. This is not because of laziness; it is because of our need to be realistic and objective. The stock market determines the price of a stock, and the volume of the trading represents the amount of interest in that determination. That determination is based upon all the factors mentioned above; the fundamental factors I will not repeat because I said you would not ever see them again in this book. But the fundamentals do not directly determine price. First they have to be passed through a very critical filter, which is the emotionalism of the marketplace. The fundamentals are only as important or unimportant as the emphasis placed on them by the millions of minds studying them. We have all seen a stock go down on a good piece of news or up on news that looks terrible, and we have shaken our heads in disbelief. That was because we were trying to predict what other people would think of that news. But the market is never wrong. It is reflecting exactly what the consensus really is. The market is a very efficient and accurate reflection of the facts, but only after they have been analyzed and then reacted to in an emotional manner. In the final analysis, the price of a stock and its volume are a reflection of a delicate balance between fear and greed. That balance is influenced by the underlying fundamentals, but is not a direct representation of those fundamentals. In using technical analysis we are deciding to study the output of those emotional responses, rather than try to second-guess what they may be, based on our limited knowledge of the “facts”. When we look at price and volume, we are looking at all the facts; they have been interpreted for us, and translated into fear or greed. It is not laziness that keeps a technician from looking at the fundamental data, is the knowledge that everything that is known about a stock has been already taken into account, and it is publicly available in the form or the price of the stock and the amount of stock that is changing hands.
The way in which the methods that follow are different than other technical analysis methods is the great dependence upon, and emphasis of, volume. It is, I believe, of paramount importance, yet it is often ignored. Many traders do not even follow the number of shares being traded, relying wholly upon price movement to make their decisions. Yet, without knowing the volume one has no idea of how much conviction is involved in a move. It is like buying a car without looking under the hood. One needs to know if that car has enough power to get over the hills. It can have a beautiful paint job, wonderful upholstery, great tires, but it is useless if it doesn’t have an adequate motor. Volume is the motor of the marketplace. We are going to be looking under the hood of each stock we trade, and seeing whether the power is there or not. To do that we are going to use my unique charting method called Equivolume.
Shown below is the type of chart we are all familiar with; a bar chart. In this case each vertical line represents one day of trading. The top of the line represents the high of the day and the bottom of the line represents the low of the day. The little horizontal line is the level at which the stock closed on that day
Across the bottom of the chart is a histogram that represents the volume. By tracing upward we can equate the volume for each day with the price action on the same day, but it is difficult to know precisely which volume applies to which price in every case. When I first thought of Equivolume as an alternative to bar charts I had already become aware of the importance of volume. I knew that it was necessary to see whether volume was heavy or light as a stock moved through an old level of resistance or support. I knew that volume tended to become heavy, and price spread tended to shrink, at important tops. I had become aware that large price swings on heavy volume were typical of climactic bottoms. I was intensely aware of volume, because it was volume that was at the foundation of my, by then already popular, Arms Index. It bothered me that volume tended to be relegated to a secondary significance, or even completely ignored at times. I felt that volume needed to be made a full partner with price if one was to understand the underlying dynamics of price movement.
When it came to me, driving home one afternoon, it was absurdly simple. All that was necessary was to combine the two pieces of information into a single posting. I would move volume off the lower margin of the chart and incorporate it in the price posting. Each day would appear as a rectangle, with the width being the volume. The top of the box, as with a bar chart, would be the high of the day, and the bottom of the box would be the low of the day. All I would be doing would be spreading each bar chart line sideways into a rectangle, as a function of the number of shares traded. The results were fantastic! Each posting started to give a much more complete picture of the trading. I found that each box was giving a concise picture of supply and demand for that stock on that day. Shown below is an Equivolume chart of the same stock over the same period we were looking at above.
The first thing that becomes immediately apparent on this chart is that all days are not the same. Compare the box marked “a” with the box market “b”. Each represents a single day of trading but one is tall and wide while the other is short and narrow. Obviously, “a” was a very significant day. There was a wide trading range and heavy volume. Box “b” was a far less meaningful day. Volume was light and there was not much price movement. Box “h” was short but fairly wide, indicating volume but lack of price movement. It was suggesting the stock was encountering resistance after the light volume rally. Box “i” was tall, but on good volume, and was saying that the stock was moving downward with vigor. The shape and size of each box has a story to tell. Let us go through all the indicated boxes on this chart, and see what they were telling us.
A heavy volume reversal day. This looked like the culmination of the decline. Heavy volume and a wide spread are typical of the final washout of a drop.
A light volume rally off the low. The lack of volume makes it far from convincing.
Here we are seeing a rally with better volume. It suggests that the low was tested, and that the rally might carry further.
Notice the very light volume on this pullback. It now looks as though volume is coming in on the upside and drying up on the downside. That is a very bullish sign.
On the next day volume explodes to the upside, penetrating the resistance we saw at “b” and saying the stock is headed higher.
After a big advance over the prior two weeks volume remains heavy but the range contracts. Perhaps the stock is encountering resistance after such a sudden rise.
This is ominous. Heavy volume to the downside and a wide trading range. If we were to insert a trendline along the bottoms of the rise, this drop would penetrate it. But the narrowness of the top suggests it is not likely to go lower until some attempt to rally is made.
The stock rallies, but the move lacks volume. It looks like a lighter volume test of the heavy volume top at “f”.
The decline resumes, on heavier volume, and support is penetrated decisively.
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