How to Track the Market's "Big Money" Elephants
Editor's note: One of the goals of this week's holiday series on "common sense" technical analysis is to "cut through the clutter." Below, you'll find a simple explanation of one of the most basic technical analysis tools... and the only two rules you need to profit off it.
I use volume to track "elephants."
Every day, the exchanges track the amount of trading volume in every stock index and security.
This volume measures the amount of buying and selling activity that was present during the day. The higher the volume, the greater the amount of buying and selling activity.
The stock market is dominated by large money managers... folks who run pension funds, insurance funds, mutual funds, and hedge funds.
Many of these managers control billions of dollars in client assets... and when they decide to enter or exit a position, they can't do it over just a few days. They have to spread their buying over months. They even have to hire people whose main job is to determine the best way to plow big money into individual stocks.
These big money managers are the "elephants" in the stock market. They create the huge moves that become market trends. And you can track elephant behavior with trading volume.
Now... we're not going to tell you trading volume is the magic key to stock market profits. But it can help you spot trends early. Here's how...
Guideline No. 1: A stock that is experiencing heavy trading volume on down days and light trading volume on up days is being sold by the big money.
The elephant tracks are pointing in the direction of lower prices.
The phenomenon of "lots of trading volume on down days, not much trading volume on up days" is sometimes called "distribution," and it's especially useful when trying to determine the end of an uptrend. Let's go back to fertilizer maker Potash Corp. during mid-2008.
You'll see some black and red bars at the bottom of this chart. These bars represent Potash's trading volume. Dark bars represent days the stock advanced in price. Red bars represent days the stock declined in price. The taller the bar, the greater the volume.
Note that in June and July, the red bars, representing volume on days Potash declined, started to get just a bit bigger than the black bars, representing volume on days Potash advanced (A). This is an early sign sellers have more power and more conviction than buyers.
Now note the tall "skyscraper" red bars in late July and early August (B). This is major selling pressure. (Even worse, this selling pressure came on the great earnings report we mentioned yesterday.) The elephants were fleeing Potash shares.
When you see a stock or stock index that's up big over the past few years start to exhibit this sort of "heavy down-volume, light up-volume" pattern of trading, it's a major warning sign the trend may be ending. A healthy uptrend enjoys big trading volume on buying days, not big trading volume on down days.
For our next guideline, we just flip things around...
Guideline No. 2: A stock that is experiencing heavy trading volume on up days and light trading volume on down days is being purchased by the big money.
The elephant tracks are pointing in the direction of higher prices.
The phenomenon of "lots of volume on up days, not much volume on down days" is sometimes called "accumulation," and it's especially useful when trying to determine the end of a downtrend.
Perhaps the stock has fallen so much that it has become an irresistible value... or maybe the tough industry conditions hurting the business are over... and large investors are taking notice.
In late 2008, the price of silver crashed in response to the big 2008 credit crisis. The metal fell from $19 per ounce to $9 in less than five months. Silver Wheaton, a company that finances early-stage mining projects, fared even worse... It fell from $14 per share all the way down to $2.56.
That's when the elephants started picking up shares...
Note the surge of buying volume in December 2008, represented by the series of tall dark bars (A). These are elephant tracks, and they signaled the end of Silver Wheaton's downtrend. The stock went on to gain more than 400% over the next 15 months.
Entire books have been written about volume analysis, and many traders use sophisticated formulas to track volume trends. The thing is, most of the time, volume analysis isn't going to tell you much.
But you can use it to help find the end of big trends... It will often signal market extremes. And for the great majority of traders, the two guidelines we just covered are all you need to know about trading volume.