Wayne Thorp will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
Last October, this column touched briefly on the equivolume method of charting, which places price and volume on an equal footing. In response to prompting from readers, this column is devoted to a more in-depth discussion of this unique type of chart. [Go to the AAII Journal area of www.aaii.com for a link to the original article.]
Technical analysis deals with two pieces of information—price and volume—in an effort to predict and measure future price movements. Traditionally, volume has been more of an afterthought, often placed at the bottom of the price chart. Price has garnered most of the attention, with an emphasis on the change in price.
Equivolume charting, however, places just as much emphasis on volume—if not more—as on price. Furthermore, instead of focusing on price changes, equivolume places more emphasis on price ranges.
Traditional charts, such as line, bar, and candlestick charts, use time on the horizontal axis. Equivolume charts, however, combine price and volume in a two-dimensional box, with the horizontal axis representing the relative trading volume. Equal distances on the horizontal axis for an equivolume chart translate into equal trading volume. The wider the rectangle, the greater the trading volume. Each box represents a trading period.
Figure 1 is a daily equivolume chart for General Electric (GE). Each trading day on an equivolume chart is represented by a rectangle. Like most other charts, the height of a rectangle represents the range of prices the stock traded at during the course of the day, while the width of the rectangle reflects the trading volume for the day. (Note on these charts that rectangles appear to the left of the date.)
Equivolume charts stress the importance of the trading range of a stock and not simply the change in price. The range represents all of the different prices at which investors were willing to buy and sell shares of the company for a given period. The trading range helps to reveal how easy or difficult it was for the stock to move on a given day.
A small trading range (short rectangle) indicates that the stock was meeting with opposition in its attempts to make a move. Any attempts to move upward were met by those wanting to sell while attempts to move down were met by buyers. In contrast, a large trading range (tall rectangle) means that the stock had a fairly easy time moving. Here the price must have moved to entice buyers or sellers to trade their shares.
The law of supply and demand is one of the cornerstones of economics and security pricing. If sellers have more of something to sell—in this case, stock—than buyers are willing to buy, prices will fall until enough buyers come forward to meet the supply of the sellers and equilibrium between supply and demand is reached. The analysis of equivolume charts focuses on this balance between supply and demand.
Volume is largely ignored and misunderstood by investors. Whereas heavy volume accompanying an upward move in prices is usually viewed as a positive sign, heavy trading volume at the end or top of the price move is often ignored. Likewise, heavy trading volume after a long decline in prices—normally viewed as being negative—could in fact be a sign that the decline is coming to an end.
By combining price range and volume into a single plot on a chart, equivolume allows you to see the interaction between buyers and sellers. These elements show how easy or difficult it is for the stock to move.
When looking at the rectangles on an equivolume chart, days where the trading spread is narrow (and volume is high show up as “short wide days.” These are days where apparently the stock is meeting resistance to an up or down move. While volume is heavy, the stock is unable to make any headway.
On days where the trading range is large on relatively light volume, the rectangles will be tall and narrow. Here, the stock is able to move rather easily.
For traders and investors alike, tops (and bottoms) are important areas on a chart. Tops are useful to shorter-term investors because they represent points to close out positions of stocks they own. For investors looking to time long-term positions, tops may serve at least as a yellow light, indicating they may want to consider delaying a trade.
There are three types of stock action: upward moves, downward moves, and sideways moves. At the end of an upward move—a top—all that can be deduced is that the upward move is over. From there, the stock can reverse course and begin to fall or enter a period of sideways movement.
During an upward move in price, demand for the stock is greater than the supply. Buyers who want the stock are bidding up the price at which they will buy it. This bidding upward continues until equilibrium between supply and demand is reached, at which point the upward price move comes to an end. This does not mean that prices will not continue going up in the future, but for now the movement has come to a halt.
Because all you can know for sure is that the immediate uptrend has ended, traders should act on only one “market phase” at a time. When an upward movement ends, it may be time to sell. However, further action should be withheld until the stock establishes itself in a new trend either up or down. Often the price will enter into a period of sideways movement, and you should wait until the price makes a move out of this area of congestion before establishing a new position.
With equivolume charting, a strong sign that an uptrend is coming to an end is increasing volume and a narrowing spread, represented by a short, wide box. This can take place on one day or over several days and often culminates in a square or “over-square” day. On an over-square day, the price is only able to move in a very narrow range, but volume is very high. Here the stock is meeting heavy resistance.
Figure 2 is an example of a classic topping formation in equivolume charting. In the uptrend that began in early July of 2001, VF Corp. VFC moved with relative ease, with similar ranges and trading volume. On July 18 there was an increase in the trading range, marked by a taller rectangle, as well as an increase in trading volume. The next day, the range dropped while volume remained relatively high. Finally, VF Corp. went “square” on July 23, after which the price began to fall. Another indication that the uptrend had ended was the penetration of the trendline drawn along the bottoms. Taking all of these factors into account would most likely lead to a sell decision.
Another kind of top is one that forms over many trading days, as is the case for AOL Time Warner AOL in Figure 3. Here the stock began 2001 in a strong upward move, with little resistance to the buying pressure bidding the price up. On January 19 the price gapped upward, breaking through the resistance level of just under $51 that had been established in mid-December. After gapping, the price settled into a trading range of between $53 and $57, unable to break another resistance level at $57.
Tops also occur when a stock meets an area of resistance, trades a large amount of volume, and eventually enters into a downtrend. In Figure 4, in the trading days preceding September 11, Carbo Ceramics CRR traded almost 1.34 million shares, or over 33 days worth of trading based on its average daily trading volume of 40,000 shares. On September 17, the priced gapped upward, through a resistance level established in early August. For the six days the price traded in the range of roughly $30.50 and $32.50, eventually breaking back to the downside.
Analyzing bottoms uses many of the same principles introduced in our discussion of tops.
A bottom is simply the point where a downtrend ends. However, it would be premature to conclude that, because the immediate downtrend is over, the price will reverse course and begin to rise. It is typical for prices to enter a period of sideways trading before either starting an upward move or continuing the earlier downward trek. While you should not enter a long trade just because a bottom forms, it is a good spot to exit short trades.
Bottoms usually form over several trading days. The initial portion of the base forms as sellers rush to exit their trades, forcing prices down at a high rate. Following this initial downward push, buyers exert their influence as they buy the stock at the “bargain” price, causing prices to rebound. However, this retrace often dies out as those who failed to exit their trades during the “selling climax” sell at the higher price. During the secondary decline, volume tends to be lighter, as the big players—specifically professional traders—have already abandoned their positions. What follows next is the “test,” where volume likely increases and the spreads narrow, creating square or over-square days. These days signal that the decline is likely coming to an end.
Figure 5 is an example of a typical bottoming pattern. Federal Express had already fallen almost 10% from its August 29 high prior to gapping downward on the first trading day following September 11. On this day, a large rectangle forms with a low of $33.29—almost 24% off the August high. Following a one-day rally, the price again tested the low of September 17 on similar volume, but with much narrower spreads. Again, FedEx attempted a rally but met resistance just below $37.50. The third decline was on even lighter volume and a narrower spread and, from there, the price entered into a period of sideways trading before finally breaking above the gap created on September 17.
Our final example shows a bottom created by an over-square day, where volume was very high while the range was very narrow. Looking at Figure 6, the large over-square day for Belden Inc. BWC occurred on April 4, 2001. After losing over 33% of its value over the previous two months, the price gapped downward to a low of $17. The trading volume on this day matched the cumulative volume of the prior five trading days.
Equivolume charts bring volume out of the shadows and place equal emphasis on it as compared to price. These charts present price and volume data in a form not found in traditional chart types. As a result, investors and traders alike are given a fresh perspective with which to identify key areas in stock price movement.