The theory behind volume states that the greater the volume, the greater the force behind the move. As long as volume increases, the current price trend should continue. If, however, volume declines as a price trend progresses, there is less reason to believe that the trend will continue. Volume can also be useful for confirming tops and bottoms. A light volume test of a support level suggests a diminution of selling force and is, consequently, bullish. Conversely, a light volume test of a previous high is bearish since it demonstrates a draining of buying power.

Although volume can be a useful auxiliary medium to measure the intensity of a price move, there are some factors with volume, especially as they pertain to futures, that somewhat limit their usefulness. Volume is reported a day late. Spread trading may cause aberrations in volume figures-especially on individual contract months. With the increasing dominance of options in many futures markets, volume figures could be skewed because of option arbitrage strategies. Nonetheless, volume analysis can be a useful tool. This chapter examines some ways volume and candlestick charting techniques can be merged.

VOLUME WITH CANDLESTICKS

Exhibit 15.1 shows how volume and candlestick techniques can help confirm double tops or bottoms. On March 22 (line I), the market pushed up to the late February highs near 94. Volume at line 1 was 504,000 contracts (all volume figures are total volume for all contract months). For the next few sessions, prices tried to push above this 94 level. The small white real bodies on these days reflected the bulls’ lack of fervor. The low volume figures on these small candlestick sessions echoed this. The bulls finally surrendered after a week. In late March, within two days, the market fell two full points.

Next we turn our attention to the tall white candlestick of April 4 (line 2). Could this strong session presage gathering strength by the bulls? The answer is probably not. First, we note the volume on this rally session was a relatively light 300,000 contracts. The long black candlesticks a few sessions before (March 29 and 30) had larger volume. Another sign of trouble appeared with the action following line 2. The next day (line 3) a small real body appeared. Lines 2 and 3 constituted a harami pattern. The implications were that the prior upmove was over. Note also that this small real body day was also a variation on a bearish hanging man (an ideal hanging-man line is at the top of a trading range or an uptrend). The next day, (line 4) there was a final surge to 94. This was a portentous rickshaw man day. In addition, this price push had relatively little force behind it as reflected by the lighter volume (379,000 contracts) compared to the volume on March 22 (504,000 contracts). The light volume test at an old high increased the chance this was a double top. The move under the March 30 low confirmed this as a double top. This double top gave a minimum measured target of 90.

We saw how a light volume test of a high could signal a top, especially when joined with bearish candlestick indications. On this chart we also have a volume/candlestick signal of a bottom. On April 27, there is a doji line. For reasons discussed in Chapter 8, doji days are usually more significant as reversals in uptrends than in downtrends. Yet, with verification, they also should be viewed as a bottom trend reversal. This unfolded in bonds. The importance of the doji on April 27 became amplified when, three days later, another doji appeared. Two doji in themselves are significant, but look at what else occurred during these two doji days. First, there was a tweezers bottom (that is, the lows were nearly the same). Note also the volume on these days. On April 27 volume was 448,000. Volume on May 2, the second doji, was almost half at 234,000 contracts. A light volume test of a support area is bullish. We see the results.

The bullish engulfing pattern, shown in Exhibit 15.2, shows that late April had a white candlestick with the largest volume in the last few months. This forcibly proved the conviction of the bulls. A light volume retest of these lows by a candlestick similar to a hammer confirmed a solid base.

There are many specialized technical tools based on volume. Two of the more popular are on balance volume and tick volume”.

ON BALANCE VOLUME

On balance volume (OBV) is a net volume figure. When the market closes higher compared to the prior close the volume figure for that day is added to the cumulative on balance volume figure. When the close is lower, the volume for that day is subtracted from the cumulative on balance volume figure.

OBV can be used in a few ways. One way is to confirm a trend. OBV should be moving in the direction of the prevailing price trend. If prices are ascending along with OBV, increased volume is reflected by the buyers, even at higher price levels. This would be bullish. If, conversely, price and OBV are declining, it reflects stronger volume from the sellers and lower prices should continue.

OBV is also used in lateral price ranges. If OBV escalates and prices are stable (preferably at a low price area) it would exhibit a period of accumulation. This would bode well for advancing prices. If prices are moving sideways and OBV is declining it reflects distribution. This would have bearish implications, especially at high price levels.

OBV with Candlesticks

As illustrated in Exhibit 15.3, the June 13 heavy selloff of silver was followed by a small real body. This harami pattern converted the strong downtrend into a lateral trend. The market traded sideways for the next few weeks. During that time, OBV was ascending reflecting a bullish accumulation. June 25 saw new price lows. These lows did not hold as evidenced by the hammer line formed on that session. The positive divergence in OBV, the failure of the bears to hold the new lows, and the hammer line supplied signs of a near-term bottom.

TICK VOLUME

In the futures market, volume is reported a day late. As a way to circumvent this problem, many technicians use tick volume to get a “feel” for volume on an intra-day basis. Tick volume shows the number of trades per intra-day period. It does not show the number of contracts per trade.

It would indicate, for instance, a tick volume of 50 trades per hour. We do not know how many contracts were in each trade. They could have been 50 single-lot orders or 50-100 lot orders. In this sense, tick volume is not a true volume figure. It is useful, though, because it is the only means of measuring the volume on a more timely, albeit less accurate,
basis.

Tick VolumeTM with Candlesticks

The hourly intra-day chart in Exhibit 15.4 shows the usefulness of tick volumeTM. After a bullish hammer late in the session on May 4, prices moved higher. However, these advancing prices were made on declining tick volumeTM. This was one sign of lack of conviction by buyers. The other was the short white real bodies. In the first three hours of May 8, there was a sharp price break. These made new lows for the move. The intra-day action late on May 8 provided clues this early morning selloff was to be short lived. After the third hour’s long black line, a doji materialized. These two lines formed a harami cross. Then a white body appeared a few hours later which engulfed the prior two black bodies.

This was a bullish engulfing pattern that had extra significance since it engulfed two black bodies. The lows made by the white engulfing line also formed a tweezers bottom.

Just in case, another hint of a bottom was needed, tick volume substantiated that the buyers were taking control. Prices rose after the aforementioned bullish engulfing pattern. During this rally, volume expanded as did the height of the real bodies. A shooting star and resistance near $1,340 from the prior week, temporarily put a damper on the price ascent. Once the market pushed above the $1,340 resistance level via a window, there was no doubt the bulls were in control.

In Exhibit 15.5, the hammer hour on June 19 furnished a sign that the market may be searching for a bottom. The first hour of June 20 made a new low at $16.62 (line 1). Tick volumeTM on this hour was a brisk 324 trades. Another move down to that level, via a long black candlestick (line 2), was made later that session. This time tick volume was only 262 trades. The next session, June 21, is the one of the most interest. On the third hour of trading, prices made a new low for the move at $16.57. This new low was made on lighter tick volume (249 trades) then the prior two tests (lines 1 and 2). This meant selling pressure was easing. Prices then sprung back and made an hourly hammer line.

OPEN INTEREST

In the futures markets, a new contract is created when a new buyer and a new short seller agree to a trade. Because of this, the number of contracts traded in the futures market can be greater than the supply of the commodity which underlies that futures contract. Open interest is the total number of long or short contracts, but not a total of both, which remain outstanding.

Open interest assists in gauging, as does volume, the pressure behind a price move. It does this by measuring if money is entering or exiting the market. Whether open interest rises or falls is contingent on the amount of new buyers or sellers entering the market as compared to old traders departing.

In this section, our focus will be on the importance of price trends accompanied by rising open interest. The major principle to keep in mind is that open interest helps confirm the current trend if open interest increases. For example, if the market is trending higher and open interest is rising, new longs are more aggressive than the new shorts. Rising open interest indicates that both new longs and new shorts are entering the market, but the new longs are the more aggressive. This is because the new longs are continuing to buy in spite of rising prices.

A scenario such as building open interest and falling prices reflects the determination of the bears. This is because rising open interest means new longs and shorts entering the market, but the new short sellers are willing to sell at increasingly lower price levels. Thus, when open interest rises in an uptrend, the bulls are generally in charge and the rally should continue. When open interest increases in a bear trend, the bears are in control and the selling pressure should continue.

On the opposite side, if open interest declines during a trending market it sends a signal the trend may not continue. Why? Because for open interest to decline traders with existing positions must be abandoning the market. In theory, once these old positions are exited, the driving force behind the move will evaporate. In this regard, if the market rallies while open interest declines, the rally is due to short covering (and old bulls liquidating). Once the old shorts have fled the market, the force behind the buying (that is, short covering) should mean the market is vulnerable to further weakness.

As an analogy, let’s say that there is a hose attached to a main water line. The water line to the hose can be shut off by a spigot. Rising open interest is like fresh water pumped from the main water line into the hose. This water will continue to stream out of the hose while the spigot remains open (comparable to rising open interest pushing prices higher or lower). Declining open interest is like closing the spigot. Water will continue to flow out of the hose (because there is still some water in it), but once that water trickles out, there is no new source to maintain the flow. The flow of water (that is, the trend) should dry up.

There are other factors to bear in mind (such as seasonality), which we have not touched upon in this brief review of open interest.

Open Interest with Candlesticks

Exhibit 15.1 on June bonds showed a wealth of information about volume. It also illustrates the importance of rising open interest to confirm a trend. Look again at this bond chart, but this time focus on open interest. Refer to Exhibit 15.1 for the following analysis.

A minor rally in bonds started March 13 and lasted until March 22. Open interest declined during this rally. The implication was that short covering caused the rally. When the short covering stopped, so would the rally. The rally stalled at line 1. This was a rickshaw man session that saw prices fail at the late February highs near 94. Open interest began to rise with the selloff that began on April 9. A rising open interest increase meant that new longs and shorts were entering the market. The bears, however, were the more aggressive in their desire since they were still selling at progressively lower prices. Open interest continued higher throughout the late April decline. When the two doji, on April 27 and May 2, emerged at the 88 V2 level, open interest began to level off. This reflected a diminution of the bears’ selling pressure.

Ascending open interest and prices throughout May were a healthy combination as seen in Exhibit 15.6. Not so healthy was the fact that June’s rising prices were being mirrored by declining open interest. The implication is that June’s rally was largely short covering. This scenario does not bode well for a continuation of higher prices. The shooting star spelled a top for the market and the market erased in four sessions what it had made in about a month.

If there is unusually high open interest coinciding with new price highs it could presage trouble. This is because rising open interest means new short and longs are entering the market. If prices are in a gradual uptrend, stop losses by the new longs will be entered along the price move at increasingly higher prices. If prices suddenly fall, a chain reaction of triggered sell stop loss orders can cause a cascade of prices.

Exhibit 15.7 is a good case in point. Sugar traded in the $. 15 to $.I6 range for two months from early March. Open interest noticeably picked up from the last rally that commenced in late April. It reached unusually high levels in early May. As this rally progressed, sell stops by the new longs were placed in the market at increasingly higher levels. Then a series of doji days gave a hint of indecisiveness and a possible top. Once the market was pressed on May 4, stop after stop was hit and the market plummeted.

The second aspect of this open interest level was that new longs who were not stopped out were trapped at higher price levels. This is because as open interest builds, new longs and shorts are entering the market. However, with the precipitous price decline, prices were at a two-month low. Every one who had bought in the prior two months now had a loss. The longs who bought anywhere near the price highs are in “pain.” And judging from the high open interest figures at the highs near $.16, there were probably many longs in “pain.” Any possible rallies will be used by them in order to exit the market. This is the scenario that unfolded in mid-May as a minor rally to $.I5 meet with heavy selling.