I set up my charts with a couple of extra volume measures. I use a normal volume histogram that can be found with almost all software packages. However, if there is a larger volume spike skewing the ability to read the volume properly I will edit the data accordingly. Next I add a 10-day moving average of the volume. This gives me a guide as to what is below average or above average volume on any given day. Lastly I add in a 2-standard deviation of the 20-day volume average. Essentially this is like the upper Bollinger band of the volume average. This shows me when ultra-high volume occurs.

With these added extra’s we can quickly gauge the personality of the day’s volume as well as benchmark it against the surrounding volume. The exact volume reading is not important. The concept of relative volume is the key.

I’m going to make reference to The Smart Money throughout this article. The definition I use for the Smart Money is:

A group of professional users that act in unison at very specific levels and points of time to change the order of supply and demand.

The Smart Money are the one’s who constantly buy the lows and sell the highs. Let me say that this is not a bunch of traders ringing around attempting to manipulate the price. We don’t need to know who or why but these are the people we wish to follow. We do so by watching their footprints and their footprints are show within the daily volume. The Smart Money will show their hands by selling into strength and buying into weakness. Now because the Smart Money can change the order of supply and demand we can therefore ascertain that strong price action may in fact contain weakness and weak price action may in fact contain strength. I appreciate that goes against most things you’ve ever learnt about volume but it’s important to keep that thought in the back of your mind. Increased supply and therefore weakness may occur during price strength. Increased demand and therefore strength may occur in price weakness.

The first thing to understand about volume is that it’s not just the volume by itself we’re interested in. A major misconception is to think that for every buyer there is a seller and in turn volume is null and void. If that were really the case then prices would simply not move. What drives prices is the fear and greed of the buyers and sellers. It’s therefore the relationship and interaction between volume and price that shows us what is really occurring in the market. Think of volume as the effort of one side and the price activity as the result of those efforts. If sellers are desperate to exit then they will be more inclined to sell at the bid rather than sit back on the offer. If there is not much buying demand below the market then prices are going to be driven lower until those sellers are fulfilled or are unwilling to pursue prices any lower. Conversely, if buyers are desperate they will buy the offer and not sit on the bid. If buyers are desperate and there is not much supply above the market then you’re going to see prices move up until those buyers are fulfilled or unwilling to pursue prices any higher. The mantra of volume analysis is:

“What is the result of the effort?”

Ever heard the truism, “buy the rumour, sell the fact”? Do you ever wonder why prices go down after a positive announcement? Do you think the Smart Money new the facts or the good news beforehand and is why they’re already long? I think so. So when the good news is announced to the market all the weaker hands jump in and start buying and the Smart Money take the opportunity to offload their positions into the demand strength.

Nick Radge has been trading and investing for 20-years. He now publishes Australia’s premier Technical Analysis market letter for stock and CFD traders wanting to learn to trade using price and volume without the hindsight. He holds an Australian Financial Services License and can be contacted via http://www.thechartist.com.au