Friday 29 September 2006

Shrinking Range and Volume

Trading volume and range shrank to a new low today.  The Emini closed down at 1,345.50 on Friday.  This is the fourth sign of weakness that we've seen in the last four days.  Keep reading below, and I'll explain how I use volume and range to find market turning points.

Volume Range Image

Volume and range combined are useful indicators of market tops and bottoms

For a market to move strongly, either up or down, it needs fuel.  This fuel is volume and the result of applying this fuel is range.  By volume I mean the number of futures contracts traded, not open interest; and by range I mean the difference between the daily high and low (note: sometimes referred to as spread).

At market tops the fuel runs out and volume and range both shrink.  Occasionally “blow off” moves can be seen, where volume and range are very high and price rises exponentially.  This pattern is more typical of individual stocks rather than stock market indices.  However, at market bottoms this pattern does work for stock market indices.

Traditional indicators can be improved upon

Volume is not well understood or interpreted in most market commentaries I've read.  The difficulty lies in combining the volume reading with whether the market is trending or range bound, whether opening and closing prices are close or far apart, and whether the range of the bar is high or low, etc.  Traditional volume indicators generally combine volume with the direction of the close and choose to ignore range.  I prefer to combine the volume reading with range and ignore the direction of the close in my calculations.

The indicator I use is not easy to explain without going into some detail.  Besides, I'd rather keep it to myself - for that reason I’ve called this indicator my Secret Weapon No. 1.  It’s plotted on the chart above and labeled Secret 1.  Daily bars with low values are painted white and bars with high values are painted red.  Today's reading on my Secret Weapon No. 1 was zero and readings of this indicator over the last couple of days have also been very low.  The fuel needed to keep the market moving up is running out.

And combining non-correlated indicators is the key

When we combine this observation with the three other signs of weakness identified earlier this week, they show a bearish picture.  If you remember on Tuesday we had the Dow racing ahead of the NASDAQ; on Wednesday we had a Trading Index (TRIN) divergence; and on Thursday a Doji candlestick pattern.  All non-correlated market indicators that together show a possible high probability market turning point.

Following-up on yesterday's comment about not being able to generate a very profitable Doji pattern trading system - I did some more testing and found a pattern that did work reasonably well.  The pattern I found consists of an up close, followed by a Harami Doji followed by an up close to generate a Sell signal.  Buy signals are obviously reversed.  Remember I'm defining an up close as the close being greater than the open.  This pattern generated a profit factor of 5.0, using large stops and bail out exit, but only 44 trades in the S&P over the last 20 years.  Today’s close was down so the pattern doesn’t apply for tomorrow.

Do a Google search for volume, range or spread to find more information.

Like this article? Sign up for Free Email Updates or subscribe to the RSS Feed.


Filed Under Volume Patterns

Popular Emini Trading Articles

Free Emini Trading Report

Emini Trading Report
Emini Trading - Free Report Coming Soon!

Subscribe to Emini-Watch