Use Market Volume Data to Determine a Bottom

Price and volume form the building blocks of market structure, carving endless uptrends, downtrends, tops and bottoms in all time horizons. Interactions between these structural elements generate convergence-divergence relationships that allow observant technicians to make predictions about direction, relative strength or weakness, and the durability of market turns.

Price/volume relationships are especially useful in identifying bottoms because profit potential peaks when long positions can be entered at or near the lowest low in a downtrend. Rather than catching a falling knife, the volume-focused trader acts early on technical signs that show committed buyers are returning to a once-depressed security.

Examine the downtrend at periodic intervals to see how it fits into a bottoming scenario. Focus on coincident volume activity that measures the balance between buyers and sellers, throwing out any ambiguous signals. Divergences are useful in this process, especially when looking for hidden buying interest that isn’t reflected in the current price activity.

Directional pressure can be easily evaluated through most phases of a downtrend because volume indicators will show sellers overwhelming buyers, or the exact opposite of the scenario expected at the bottom. In addition to trade flow, look at average volume day-to-day as the downtrend progresses because bottoms rarely form until one of two events takes place:

• The security undergoes a climactic sell-off that leads to three-to-five times the average daily volume, often over a number of sessions.
•  The security enters a dormant phase where it continues to fall while volume dries up, leading to lower than average daily volume, often for weeks or months.

The first scenario triggers a buying imbalance because intense selling pressure reduces the supply of new sellers, giving buyers an advantage, while the second scenario indicates that sellers have moved on to other opportunities, allowing value players to start the process of bottom building. It is counterintuitive, but a security in a low-volume decline will often take longer to show a durable bottom than one in a climactic free-fall.

Volume histograms found at the bottom of most price charts do a good job of identifying and confirming bottoms when analyzed correctly. In the first scenario, the trader looks for a selling climax that yields one or more high volume bounces that indicate short covering. This price and volume activity doesn’t signal an immediate bottom and new uptrend. Rather, it forms the outline of a bottom that can take additional weeks or months to complete.

A bullish volume shift can be harder to find in the second scenario because beaten down securities can drift sideways to lower for months before acquiring the sponsorship needed to enter a new uptrend. New money often enters quietly in these patterns, triggering slightly higher than normal buying days within long-term trading ranges. These upticks don’t trigger breakouts and are often ignored by technicians because they don’t stand out on the price chart.

However, the sum total of this buying activity builds a positive feedback loop that carries the price up to a notable resistance level. A high volume breakout often follows immediately, shocking chart watchers who haven’t paid attention to the small details. As a result, watching this quiet accumulation and entering a trade at range resistance can produce outstanding profits.

THREE YEAR LOW VOLUME BOTTOMING PATTERN

Boston Scientific Corp. (BSX) dips under the 2008 bear market low in 2010, entering a bottoming pattern that lasts for more than two years. Weekly volume drops precipitously in 2011 and 2012, pointing to extreme apathy in the middle of a raging bull market. The security quietly carves out a weekly descending triangle, breaking the upper trendline and 50-week exponential moving average (EMA) in January 2013, setting off a new uptrend that shows rapid progress.  

In both scenarios, watch the volume when price finally rolls over and tests the downtrend low. It’s bullish when the test generates lower volume and price turns higher above the prior low. Undercuts to new lows are common in our modern environment, but these can still yield legitimate bottoms when volume aligns correctly and price recovers quickly, closing back above the prior low.

TRADING A BULLISH VOLUME DIVERGENCE

On balance volume (OBV) offers a useful technical tool to gauge the durability of a potential bottom. Watch the indicator during the test of the prior low, looking for it to carve out a higher low. This pattern can draw wide attention, encouraging sidelined participants to open long positions in support of a new uptrend.

It’s especially valuable when price dips below the prior low while OBV holds above it, signaling a bullish divergence. That’s what happens on the Expeditors International of Washington, Inc. (EXPD) chart after the security fell more than eight points over three months. The higher OBV print revealed hidden buying interest, ahead of a recovery wave that returns to the yearly high.

Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls, allowing them to get on board before the crowd discovers the new uptrend.