Use “The Force”: Harnessing Volume to Predict and Understand Stock Prices

“A Jedi’s strength flows from the force.” — Yoda

Dear Penny Sleuther,

Although market volume is a crucial piece of investment information, the majority of the public is ignorant of it. Fundamental analysts do not consider volume, whereas technical analysts underutilize it. In my new book Investing with Volume Analysis I discuss how volume provides essential information in two critical ways: by indicating a price change before it happens and by helping the technician interpret the meaning of a price change as it happens.

Here’s a look at how you can harness the power of “the force” to predict and interpret price action in small-cap stocks…

Volume Leads Price

Although practitioners of technical analysis and academia have often been at odds, volume information is one area where they tend to largely agree. Volume can provide essential information by indicating a price change before it happens.

The message is extremely telling, particularly when the volume reaches extreme levels. During such times, volume offers far superior information than price alone could ever provide. Authors Gervails, Kaniel, and Minglegrin of “The High Volume Return Premium,” a white paper from The Rodney L. White Center for Financial Research of The Wharton School, University of Pennsylvania state, “We find that individual stocks whose trading activity is unusually large (small) over periods of a day or week, as measured by trading volume during those periods, tend to experience large (small) subsequent returns.” The researchers further state, “A stock that experiences unusually large trading activity over a particular day or a week is expected to subsequently appreciate.”

The testing results of their 33-year study comparing stocks that experience relatively high volume surges compared to normal and low-volume stocks is illustrated in the chart below. Similar conclusions were confirmed by Kaniel, Li, and Starks of the University of Texas. Their research paper, “The High Volume Return Premium and the Investor Recognition Hypothesis: International Evidence and Determinants,” concludes:

“We study the existence and magnitude of the high-volume return premium across equity markets in 41 different countries and find that the premium is a strikingly pervasive global phenomenon. We find evidence that the premium is a significant presence in almost all developed markets and in a number of emerging markets as well.”

Source: “The High Volume Return Premium,”
The Wharton School University, Pennsylvania

Volume Interprets Price

The second critical way in which volume provides information is by helping traders interpret price.

Volume enables the analyst to interpret the meaning of price through the lens of the corresponding volume. The authors Blume, Easley, and O’Hara (1994) reported in “Market Statistics and Technical Analysis: The Role of Volume,” in the Journal of Finance, “volume provides information on information quality that cannot be produced by the price static. These researchers demonstrate how volume, information precision, and price movements relate, as well as how sequences of volume and prices can be informative. Moreover, they also show that traders who use information contained in market statistics do better than those trades who do not. Thus, technical analysis arises as a natural component of the agents learning process.”

However, price alone represents the vast majority of the work within technical analysis. As such, this book gives volume the significance it is due as an essential element of investment analysis.

Yet doing so without also discussing price is also insufficient. Volume cannot be properly understood without price any more than price can be adequately assessed without volume. Independently, both price and volume convey only vague market information. However, when examined together, they provide indications of supply and demand that neither could provide independently.

Ying (1966), in his groundbreaking work on price-volume correlations, stated, “Price and volume of sales in the stock market are joint products of a single market mechanism; any model that attempts to isolate prices from volumes or vice versa will inevitably yield incomplete if not erroneous results.”

From my research I have found that volume is a very valuable variable in stock analysis and its effects are more significant upon smaller capitalized overlooked securities. As such, I believe this translates well for the penny stock investor looking to employ volume analysis concepts into their own research efforts.

Sincerely,
Buff Pelz Dormeier, CMT
Penny Sleuth

April 15, 2011

Editor’s Endnote: To learn more about integrating volume into your trading, Buff’s new book, Investing with Volume Analysis, provides an accessible in-depth view of this essential technical metric. To grab your own copy, and profit from the hidden forces behind market moves, just click here…

Excerpted with permission from Investing with Volume Analysis: Identify, Follow, and Profit from Trends by Buff Pelz Dormeier (FT Press; 0137085508).

Use “The Force”: Harnessing Volume to Predict and Understand Stock Prices was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

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