Volume ... more thoughts on weak stocks

When I last wrote on these pages I was attempting to develop thought and charts to explain how I see volume. We started with stocks that were declining and the initial set were stocks that saw huge (price wise) declines in short periods of time. These charts exhibited large volume spikes on large downside prices declines. I had tried to distinguish between distribution versus stops being hit and naturaly (though hurried) profit taking occuring.

In this iteration on volume tells, I'm looking at weak stocks where volume and price declines are not sudden as before. These types of declines, when they persist, are almost always a sign of consistent distribution occuring. That distribution is from both large and small players and I suspect, is the consistent cashing out by larger holders at prices that still make them fortunes. The ones holding the bag in these cases, are all the little folks who bought the story associated with the stock and whoose approach to stock investing/trading is to buy and hold. K has shown a consistent uptrending pattern for a good two years now until the past three month where it has began to trend lower. This lower trend is concerning if you are long because it is reaching that critical point where it is either going to begin to exhibit a perpetual crawl towards lower prices or it will find support and begin to trend higher once more.

The typical pattern that I'm looking at in this and the next chart is that you have some sponsor or sponsors of the stock during the price rise. The story is good and everyone wants to buy it. It's likely that the larger holders of the stock have gotten a special deal and are sitting on huge profits after the two year run. As the stock begins to weaken (either because the story was false/fake and/or because the fundamentals have changed) the larger holders start to distribute into the late comers, folks who are unaware that the trend is changing. The story is still told and the blind buy, but those who are in the know are slowly getting rid of their stock. Note, they are holders of hundreds of thousands of shares. It takes them a while to distribute their stock. That distribution usually takes place towards the top; at the topping phase; and all the way back down.

Take this next stock which has made the complete trip already, WLV. This stock was given a story and that story was sold to the public (look back at the press clippings if you don't believe me). It was the best thing since sliced bread. As it neared a topping point, the insiders we likely selling as fast as they could without crumbling the price too much. They did that all the way across that long topping pattern for a year in late 2004 through late 2005. When the price broke though, they distributed what they had left all the way down and finally the late comers were washed out at new lifetime lows just recently on a nice volume spike. Now the bottom feeders will likely come in again.

This article along with the previous one exhibits the two common patterns associated with declining stock prices and it attempts to distinguish between distribution and profit taking/stop losses as that's the key to staying out of trouble. The golden rule is that if you can't distinguish between the two on a given chart, then simply stay away. There's other places to spend your money rather than flipping the coin. The other golden rule is that you usually need not be in a hurry to buy a weak stock. Even if it's distribution, there is almost always a retest of the lows before a sustainable rally can occur. This gives you and entry and exit point you can live with. That's the safe way to play long entries on such chart patterns.

Volume; a continuing analysis ...

In the last post, we left off with the idea that we have limited information on volume; namely an overall count, a correlation of volume with price and the direction of those prices. Given this limited data, and after looking at literally hundreds of thousands of charts over the years, I would suggest that the following statements are true and useful when analyzing volume:

1. If we have daily volume, we can construct a moving average of volume
2. If volume on a given day is much higher or much lower than the average volume, then that probably has some significance
3. For definitions sake, we can assume that an up volume is a day where the closing price today is higher than the closing price yesterday. A down volume day would be the opposite
4. We can also assume that the interpretation of volume will likely be impacted by the underlying trend of the stock being examined
5. Volume needs to be interpeted as part of the overall picture. Volume and price go hand in hand and although volume will precede price in some cases, interpreting volume without the help/context of price data is like panning for gold in your bathtub
6. Not only do you need to interpret volume in the context of price action in the stock you are examining, but you also need to consider price action in that stock's sector and the general market as well

All of these things I both believe in and use in my interpretation of volume. When I look at a chart, I look at both price movements and the volume that accompanies those price movements. For me, the key tell in a chart is whether or not volume gives us more information about why price is doing what it's doing. In some cases, it gives us no additional but in those cases where it does, it strengthens our belief in what the future price action should be based on our intrepretation of what that volume and price tell us.

The simplest way to consider what volume tells us is to look at some charts. Rather than picking charts in the past and saying, here's what it should have told us, instead I'll pick current charts and tell you what I believe it is telling us now.

Distribution Versus Correction
The difference between these two words is critical. Distribution is a continual pattern of selling into strength to distribute your shares to others. When large holders of a stock distribute, that stock cannot be owned until they have finished. A correction is usually reasonably short in duration and the stock can be bought when the correction has ran it's course. Stocks that are distributed take a long time to get back to their previous highs. Stocks that correct can do so relatively easy. When you are looking at a chart that is undergoing either distribution or a correction, this is what you are attempting to decide; which is it?

Chart Ambushed

Let's start with a chart showing a very bullish stock that has suddenly been ambushed. I've chosen the chart of MIND which has just suffered a huge spill moving from a high of $26 to $20 in about 8 days. Now I wouldn't want to buy this stock right here, right now, but I would suggest that the volume spikes signify scared longs taking profits rather than large holders of the stock liquidating and never wanting back in. How can I draw such a conclusion?

The first observation is that we had a huge run up in price without a consolidation from $19 to $26 and that was after only a brief consolidation that followed a run from $12 to $19. So essentially, prices more than doubled without much of a break and in all of this transpired in about a 3 month time frame. This stock needed to be ambushed.

A second observation is that the price correction has occurred during a total of 3 days. Unless some fund which had a large position in this stock either went belly up or decided that they had to get out at any price, then this is instead liquidation by longs that were either overextended or ready to bail out at any price. If you consider this objectively, it was likely the latter case, not the former.

Thirdly, the price depreciation accompanies a sell off in the general market. This also suggests profit taking.

Lastly, the down volume bars are not as large as the up volume bars of the recent past. When this occurs, more weight is added to the idea that we are correcting, not distributing.

Given the above, this is likely a stock that is NOT undergoing distribution but instead a correction. That doesn't mean you should buy it here, but it does mean that it can be bought again and relatively soon probably.

Here's another chart that looks about the same as MIND. In this chart, ISRG, the correction is even deeper. That's another item you have to consider. I like to consider the 50 and 200 day moving averages as key to understanding stocks. If a stock closes under the 50 day moving average, it has an increased probability of falling further towards the 200 day moving average; not guaranteed, but increasing likely. Although ISRG has the same type of volume pattern reads as MIND, it appears likely that it wants to correct as far back as $80 or so which is where we find the 200 day moving average and a large gap up area. Note that the down volume bars are larger than the recent up volume bars. That's a warning sign that the correction is likely deeper and adds a bit more weight to the idea that it could be distribution versus correction. Given that the majority of the signals suggest correction, not distribution, that's my read here as well.

Here's another chart. This is ITMN and it appears to be undergoing distribution versus a correction. Can you see why? In this chart we see some differences from the prior two. Here we see a stock that traveled fast, like the others towards higher highs but in this case, the highs happen to coincide with previous highs. After a poke higher, a small retrace and a second attempt to reach higher highs, failure set in and then a collapse on gap down move.

Look at the recent volume bars. The three largest volume bars over the past 6 months were down volume days and that's despite a stock that has climbed tremendously in price. Note that the higher high came on lighter volume as well.

My guess is that this stock is likely being distributed, rather than just correcting. It's stocks like these that should be considered as potential short candidates or, if you want to trade long only, avoided. Here's one more. Distribution or Correction? My take is distribution. Again a double top and then a big gap down on earnings. It's likely those with larger positions will sell any rally attempts in the coming days and weeks leaving this stock under pressure for a reasonably long time.

Down Trends and Volume Tells

Although not foolproof, if you pay attention to price and volume you can read a chart when it is falling in price. You can many times ascertain the important answer as to distribution versus correction. Distribution you can short into or avoid while corrections can provide great opportunities to get long again and again.

In the next issue, we'll look at stocks that are weak, but volume isn't spiking to see what that tells us.

Volume - what does it Mean?

I've remarked many times that there are three factors that, if understood well, will go a long way to improving your technical analysis of the market. Like everything else, they are not foolproof yet they do consistently produce results which is why we trade the market. These three factors are time, price and volume. I propose to do a series on the three factors here starting with volume.

Volume
What is volume? In the most simplistic terms, volume is a statement of intent. There's up volume and down volume. For individual stocks, you will not find such a listing though although for the indexes you get an aggreate of this across all stocks in that index. That doesn't mean that the data doesn't exist, it's just not available. You can get a sense of up versus down volume from the charts however by assuming that a day where prices increase you count that as an up volume day and vice versa when a stock declines, that's counted as a down volume day.

But what does it matter whether the majority of the volume is occuring on an up day versus a down one? Why should one care?

Why Volume Matters?
Volume is the essence of supply and demand and in the end, the supply and demand is what moves prices. Since we trade in order to make money, it's important to understand if there are more buyers or sellers of a stock at a given point in time. Volume can help to tell you that.

The other thing volume does is that in many situations, volume precedes price. By that I mean that volume signals occur before price signals. When larger buyers are either accumulating a stock or distributing it, they typically leave their footprints in the volume bars. Sure it will be reflected in the price as well, but its in the volume bars that we can make sense of what price is doing and many times volume signals will clue us into what price is about to do.

So if volume can tell us so much ... how can we make sense of it?

Interpreting Volume
The most significant problem with interpreting volume is the scant information we have to work with. First of all, as mentioned above, we don't have a day-to-day accounting of how much volume was a buyer hitting the bid versus a seller hitting the bid ... in other words, who was initiating the action. That would be the cleanest data if it were available. Instead, what we have are the following:

1. Over all volume on a intraday, daily, weekly, and longer time frame
2. Price that correlates with the above volume time frames
3. Direction of prices - the short, intermediate and long term trends for the time frames being studied

... more to come ...

Discerning the difference between short covering and real buying

When a market has been bullish for a while, there is a tendency to see sharp short covering spikes occur. They are driven by nervous shorts who run for cover thinking that maybe they are wrong again as well as over anxious bulls who want to call the bottom. The difficulty is determining whether a snapback against the trend really has staying power or is simply a short covering rally that is destined to fail.

There's no hard and fast way to determine which is which, but the proof of the pudding is usually found in the volume. A short covering rally will look just like a lasting move in that volume on the way up will gather strength and crescendo with a nice increase over recent volume. That part looks the same. What is typically not the same is how things look on the way back down and the subsequent attempt to push higher. If you high volume on the way back down or less volume on the secondary attempt to push higher, you are likely witnessing a short covering rally and nothing more.

Although there are other sign posts to look for like, the quality of the rally (is it broad or narrow), whether it is driven primarily by futures buying, whether it is centered in speculative stocks mostly, etc., paying attention to the volume story is the most critical factor to observe.

Avoiding the pain at the edges

There are three trends to a market based on time frames; short term, intermediate term, long term. Unless you are a buy and hold or maybe short and hold type of person, the long term doesn't offer a lot. The short and intermediate term, however, hold promise.

When a market is moving in a given direction, the majority is right, except at the edges. Think about it for a minute. If the market is moving higher, then the only reason it is moving higher is because the majority of the money is on the buy side and thus the demand for stocks is greater than the supply. When the demand outstrips supply, prices move higher. If there is more demand than there is supply, the majority of the money is necessarily on the buy side. Taken further, when a market is heading higher, the majority is not just true of dollar terms but also true of players since the majority of the players are smaller and the smaller players are typically buyers of stock, not shorting stock. When stocks head lower, eventually the majority of the players also becomes sellers (although they are selling previously purchased stock, not shorting). Thus, the majority is right again ... until the next turn/edge arrives.

It's only at the edges where the majority is wrong because the where a change in direction truly occurs, the majority will necessarily become the minority. The rest of the time, the majority is right.

Now how can a trader take advantage of such knowledge? The obvious answer is that if you are an early adapter to the change in trend, then you are less likely to feel the pain that a turn causes. You don't necessarily need to take the other side of the trade but you do have to do some selling when the majority are forcing stocks higher just as you have to do some buying when the majority are selling.

In the next conversation, I'll talk more about how to avoid the pain of a turn in more detail. It's probably one of the most crucial points in how to outperform the markets.