An Unconventional View of Trading Volume

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1 An Unconventional View of Trading Volume With all the talk about the decline in trading volume (over 30% on a year- over- year basis for most of the third quarter) you would think that no one is playing the market. Absolute levels of shares or futures contracts traded, compared to some historical benchmark, have long been used as an indicator of market conviction. Does the trading volume validate the prevailing uptrend or downtrend? Meaning is the trend in price, in any given market, supported by elevated levels of trading activity? This has always been interpreted as a sign of how strongly market participants believe in the move and therefore how reliable it is. More volume = more conviction. In today s market environment it seems to be a misleading indictor as the Dow, S&P, and NASDAQ forge higher on a daily basis without the support of high trading volumes. Does this mean portfolio managers and traders should ignore trading volume as an indicator of future price movements? No, but maybe they should analyze this important data in a very different way. Now some market observers are analyzing how trading volume is distributed over price to see the real supply/demand characteristics of a given market, for a given time frame, regardless of the overall level of activity. The result is a graphic depiction that looks very similar to a histogram, with the exception being the graph is displayed vertically against the y- axis (price) versus horizontally against the x- axis (time).

2 S&P 500: Volume over Price Chart from the August 31 st Lows through today Important support comes in at 1183 as this is the high volume price or mode of the chart since August 31 st. Source: CQG These graphical formations provide a much more comprehensive view of what most market participants would refer to as support and resistance levels. The pictures also shows when a market is transitioning from a range mode to a trend mode (see picture above for an example of a market with a supply/demand imbalance), thus enabling managers to not only make directional and timing adjustments but also prepare for changes in volatility. How do they do it? Using basic math and statistics it is possible to calculate if a market is range bound or has an imbalance that projects a new high or a new low. Analysts simply look at displays of time over price or actual trading volume over price to see if a curve (think bell shaped curve) is balanced or

3 unbalanced. Notice in the picture above how the curve has a clear skew towards the higher prices. Using simple measures of central tendency such as the mid- range of price activity (the high over a given time period plus the low, divided by 2), the high volume price (price level with the most traded volume) and balance point (equal amount of volume above and below a certain price) traders can determine if a market will mean revert or go on to make new highs or new lows. The chart above is unbalanced and tells us the S&P 500 has more upside, potentially as high as 1310, so traders should be looking for places to BUY. When all three measures of central tendency come together the curve is balanced. Notice in the chart of the Oil Services ETF (below) the mid- range, high volume price, and balance point all come in around $

4 HOLDRS- Oil Services (OIH): Volume over Price Chart from the August 31 st Lows through today Fair Value since August 31 st comes in around $ Source: CQG In this scenario traders sell the top tail (top 15% of the curve) and buy the bottom tail (bottom 15% of the curve) and look for a move back to fair value ($118.75). This is when a mean reversion strategy is most effective. When there is a skew in the distribution (the high volume price is above the mid- range, which is bullish, or the high volume price is below the mid- range, which is bearish) traders hold positions with the expectation that a new high or new low will be achieved and disregard a mean reversion strategy.

5 Why is it important to understand this relatively new method of analysis? As the time horizon for holding positions continues to decline, markets become increasingly prone to trading swings generated by chart- based, quantitative, and assorted black box algorithms, not to mention high frequency trading (think Flash Crash for the extreme case). Therefore, it is critical to understand when a market is simply rotating around fair value or if a legitimate new trend is developing. Using actual depictions of trading volume over price as a basis to determine range bound or trending markets as opposed to fundamental or quantitative models proved very useful in 2008 when time and again valuation metrics failed to predict the one way freight train to the March 2009 lows in equity markets around the globe and again missed the turn higher. Using market price action as a guide is not a new concept but the ability to more accurately gauge timing, direction, objectives and incorporate the latest price and volume data to determine the state of the market, balanced (range trading) or unbalanced (trending) is giving market participants a new tool to guide them through the increasingly noisy and unpredictable environment created by so many different strategies with so many different time horizons. This dynamic form of analysis has allowed its adherents to cast off the form fitting caused by an external view of what the market should do versus what it is actually doing. In fact, since early September (when the S&P was trading around 1080/1100) supply/demand analysts have been looking for the S&P 500 to make a move to the 1160/1170 area and then onto 1250/1275 (despite weak levels of overall trading volume, mediocre economic data, and less favorable seasonality). Liquidity is another much sought after goal in any market and here again using graphs of volume distributed over price visually show portfolio managers and traders at what price levels the market is deepest (high volume area) and conversely where a market should trade thin (the tails). This takes the guess work out everything from traders trying to execute daily orders to beat VWAP

6 (Volume Weighted Average Price) or long- term portfolio managers trying to figure out what is fair value in a given stock over the last five years. As this last point implies this tool is not just a short- term intra- day technical indicator but now vendors allow for the volume data to be aggregated over weeks, months, and even years. In essence this allows analysts to peer into the portfolios of the largest commercial money managers in the world because they can actually see at what price levels the largest positions have been established. The data is also available for just about every exchange traded market so the analysis can be completed across asset classes as well as time frames. Given the richer information content embedded in these pictures more market data providers are developing functionalities to allow for this kind of analysis. It is now standard fare on such platforms as Bloomberg and Commodity Quote Graphics (CQG). It is not inconceivable that when an analyst goes to look at a chart 5 to 10 years from now it will not be a traditional bar or candlestick chart but rather a volume over price histogram.

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