The Danger of Low Trading Volume

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 |  Includes: DIA, QQQ, SPY
by: Babak

As a technical analyst, I normally look at price action exclusively but volume is undeniably, another important element of the market. I’m a bit reluctant to delve into the concept of volume because a lot of what is already out there is bunk.

In any case, here is an interesting chart of the recent NYSE total volume (5 day simple moving average) and the S&P 500 Index (SPX). It shows that, usually, when trading volume dries up the market tops out.

Although it isn’t marked on the graph, I’m sure you’ve already noticed that the opposite seems to also be true: when volume screams higher, propelled by frenzied trading, more than not, we have an important floor put under the market.

The recent market condition did provide us with such a spike high in total volume, but it was short of previous ones in January 2008 and October 2007. I’m a bit concerned that volume has dropped to a fairly low level already. On its own this wouldn’t mean that much, but it is one more addition to the already growing list of indicators blinking a caution sign.

For obvious reasons, the time around the end of the calendar year and the start of the new year has to be excused from this analysis. Furthermore, since total volume drifts slowly higher, comparing a time horizon longer than a few years gives us problems. As well, this isn’t a 100% reciprocal relationship, the “?” points out an instance where price continued higher, even after a period of very low trading volume.

There are more advanced ways of looking at total volume that would mitigate such structural short comings (for example, using bands and seasonally adjusted data) but I simply wanted to introduce the concept. You can run with it and report back.