Although Volumes Ratio is definitely a technical indicator, it is probably one of the least objective technicals methods widely used. However, not a single trade deal is executed in the financial markets without taking in count volumes. The reason why we consider the Volumes Ration indicator is one of the least objectives is that there are no immutable rules here. Instead of that, there is a number of general considerations which have to be interpreted in a given market context. And the only way to interpret them exactly is watching the price action every day and learn to feel the difference between ‘normal’ and ‘large’ or ‘small’ volume. The following list gives a general understanding. We will also demonstrate them for different trading scenarios.
Important Volumes Ratios.
The volume is seeking to move together with the trend which means that the volume aims to be larger with the growth and smaller with the decline of the price during the bullish market. Bearish price action means the opposite. The only exception is when the market is reaching a potential retracement which is related to the following consideration.
During an intermediate climb (bullish or bearish), an overbought market is trying to decrease the volume on climbs and enlarge the volume during declines. On the contrary, during an intermediate decline, an oversold market is seeking to enlarge the volume on climbs and decrease it on declines.
Bullish market trends end during a period of unusually large volume (compared to previous periods) and start on a small volume almost always. And, on the contrary, bearish markets start with a large volume and end with a small volume almost always.
The third consideration deserves a deeper study in the scope of an example shown on a long-term chart of OTC market with volume ratio added to the chart. If you look at that part of the chart where the trading volume is indicated, you will see that starting from January the trading volume starts to enlarge. This is especially interesting because during the whole year 1991 OTC sector was going much faster than the other indices and it had rather a big volume even before. If you look now at the volume ratios of a comparative chart between Dow Jones, OTC Composite and S&P500, you will see a significant difference between volume ratios. Namely, during the sell-off in April and May, the Dow Jones and transport sector volumes have been declining significantly while OTC Composite and S&P500 volumes stayed large compared to the previous periods.
This is the key reason why an investment consulting edition ‘The Rand Monitor of Market Risk’. dated February 20, gives an advice for institutional subscribers to ‘hold long positions for cyclical securities and shift to a minimal presence in OTC market and shares with the strong growth pace’. OTC, S&P500 and some other leading market indices were demonstrating classical technical signs of reaching a top level according to almost all of the aspects. This suggestion was confirmed by the trading volume which was on a high level during the last climb and the following sell-off as well. Over-the-counter securities market, in particular, was long since matured for at least a significant correction, and according to the opinion of many analysts, had the leading role in the latest growth and the followed sell-off. In the same manner, Dow and other cyclical indices were showing a bullish activity decreasing the volume while going down and increasing it on upside spikes. This factor had a significant influence on traders who decided to play the market on both sides taking long positions for cyclical equities and short positions for OTC and rising shares.
This leads to another important but secondary principle of the technical market analysis which not so many traders use for the general market. Relative strength. Traders could get relatively good market feeling 10-15 years ago analysing Dow Jones Indices for transport and utility companies. Now, when the information technology development allows to isolate and analyse different market sectors separately, a much wider scope is needed for the whole market understanding. A wide market watch should contain 18 indices with close daily prices, grade and duration for every one of them. In this case, the basic Dow analysis theory is used. This theory compares price action monitor, volume ratios and width (ratio of climbing/declining shares number) in order to see similarity or difference between many indices.
All of the indices will have the same direction on a strong bullish market. Some of the indices like Dow for industrial companies or XMI (Major Market Index which is a synthetic index of major American corporations) move together in a mixed strength and weakness of the economy such as the economy nowadays. At the same time, some of the indices move faster or lower than others. In other words, the relative strength is the comparison to be found by traders. Robert Ria refers to the relative strength concept in his phrase: ‘shares habits and how they behave in relation to each other’. Although he means separate shares, it is necessary to assess indices now and how do they behave in relation to each other. As we already mentioned earlier, S&P500 and OTC indices were going faster than wider indices like Dow and AMEX in 1991 - they had a larger relative strength. In order to make more precise forecasts for the future, it is important to identify the relative strength of different markets and their influence on the trading process overall. You do not need to be a genius to realize that OTC market was the strongest one in 1991 when you analyse different markets.
But the following is intuitively obvious. As long as the OTC market was the strongest one for so long and in such a speculative environment, it would be the first one to plunge on the overall market decline and the plunge would be most impetuous - when a sideboard shelves break off, the porcelain above it would be crushed most likely.
200-day moving average.
Although this is not related to the current example, another key secondary technical indicator to watch is 200-day moving average. The first time it appeared in 1968 as widely used when William Gordon research results have been published. These results had demonstrated that buying and selling shares of Dow Industrial companies based on the only 200-day moving average, an investor could reach 18.5% of an average yearly profit.
Using 200-day moving average.
If the 200-day moving average flattens out or moves ahead after a previous decline and prices break through the 200-day moving average on the upper side of it, then this event is a long-term buy signal.
If the 200-day moving average flattens out or moves ahead after a previous climb and prices break through the 200-day moving average on the lower side of it, then this event is a long-term sell signal.
The only serious problem with 200-day moving average is that it is a very lagging indicator. If you open any long-term Dow chart you will see that when the 200-day moving average indicates a buy or sell signal, most of the price action is already over. Moreover, it is almost useless in protection from a sudden collapse after a continuous speculative market climb. This is why 200-day moving average should be used only as a supportive secondary indicator. If, for example, OTC Index, apart of everything else, would also breach the 200-day moving average downside, traders could put the world on a short position for OTC Index in April and May. Instead of that, there were some moderate short positions held by the market players.
The width and momentum oscillators.
The last two indicators which are widely used as the secondary ones are the width or climb-decline line as it is called sometimes (or Advance/Decline line) and momentum oscillators. A/D line is just an expression of the difference between the overall number of climbing shares and the overall number of declining shares. The importance if this indicator is in compensation of almost all of the weighted stock indices. Dow, for example, has only 30 as the average number of volume weighted shares. Sometimes, when a heavy-volume share like IBM is making an unusually large spike, this might bring to nought the index’s value as the indicator of the shares performance for industrial companies in general. Usually, daily A/D line action follows the general direction of wider indices, and when this does not happen, the signal about possible changes in the current trend occurs. Actually, A/D line is used as an additional indicator together with Dow theory in different indices analysis. Although, the daily A/D line should confirm the previous top (or bottom) only but not the top or bottom which it is compared with. Besides that, the weekly A/D line should confirm your bearish or bullish suggestions. For example, the weekly A/D line is the best technical indicator starting from the bottom in October 1990, without any exceptions. And there is another example: Dow showed new highs in March and April 1991 while S&P500 and ‘width’ did not. Such a situation could be considered as a possible divergence which would indicate Dow approaching a top.
The ‘width’ has to watched always and it has to be considered as an equivalent of any other index. The data received from it is secondary and additional but it creates a momentum oscillator which shows the common market bias up or down in general. A daily cumulative total of difference between rising and declining shares’ number has to be calculated every day for the last NYSE 30 trading days. This result has to be divided by 3 in order to get a width oscillator which is the equivalent of 10-day moving average which reflects the pure change. This is often an effective instrument to measure the medium-term overbought or oversold market conditions.
Width and momentum oscillators are used together with the 200-day moving average to increase the effectiveness of basic technical methods such as ‘1-2-3’ criteria, ‘2B’ rule and duration profiles to determine the overall success chances. For example, width failed to show new highs in March and April. According to the long-term oscillators, the market was in slightly overbought conditions. Therefore, width was supporting my OTC short positions as well as oscillators were confirming them softly. General chances were in favour of that but not as much as taking an aggressive short position. Not more than 2-3% of a traders’ capital should be under the risk in any single moment.