FRED GOODMAN'S KEY INDICATORS FOR INVESTMENT SUCCESS
Volume Oscillator
Wednesday, August 28, 2002
Fred Goodman
Volume speaks volumes -- and this oscillator helps us to listen.

Let's look  back in time to gain some insight into how volume can be used to make decisions about the direction that the market is likely to take. Now please keep in mind the fact that these are retrospective analyses and, as such, they can never be wrong. Of course we are going to try to fit the past to the today's situation because we would all like to be able to see into the future. With that in mind, just follow along with the analysis and then we will try to make a decision about the immediate future.

The "volume oscillator" is produced by dividing the 10-day moving average of NYSE volume by the 25-day moving average, and subtracting 1 from the result. It is fully desrobed in Martin Pring on Market Momentum, pages 274 to 276 (terrific book -- click here to order it now). When the oscillator drops, it indicates that the 10-day moving average has declined relative to the 25 day oscillator. You can vary the number of days to produce either a long or a short term indicator. I find that 10/25 works well for me.

The black arrows point to periods during which the volume oscillator dropped sharply. In almost all of the cases on this chart, most of which happened during a bear market, low volume was associated with a market top. The high peaks, more times than not, were associated with an oversold market ready, or in the middle of a decline. There have been several peaks in volume associated with the beginning of a period of quiet lateral trading. Since you are looking only at the bear market, please reserve judgment until I show you some earlier charts.

Volume Oscillator Through Thursday, August 22nd

Looking further back in time, below, I have used green arrows to highlight volume extremes before bullish market moves and red arrows before volume extremes prior to bearish market moves. In the fall of 1997 there was a decline to around 835 in the S&P 500 during the so-called "Asian Contagion." That period is represented by the first green arrow as the volume oscillator made a high during the market decline. High volume periods almost invariably will occur during a severe decline.

Here the black arrows point to extremes in volume, above 10 or below -10, during which there was a consolidation in the S&P Index. I use these arrows to point to consolidations in a trending market, whether the trend is up or down. Notice that after a rally or a decline, during which the volume increases, there is a period when there is little movement either up or down. The black arrows are used to highlight those periods. The third green arrow came during the W-shaped bottom formed in the fall of 1998 during the period marked by the failure of Long Term Capital Management. There were several consolidations during the rally that followed, then, at the end of 1999, there was a major drop in volume just before a two and a half month decline that preceded the final blow-off in March 2000.

Volume Oscillator November 1997 to April 2000 Through Tuesday, August 27th

Now let's move forward in time in the chart below. Following the blow-off in March 2000, there was a low-volume consolidation, and then, at the August top, there was a drying up of volume that proved to be the last gasp before plunging into the abyss. The low volume rally demonstrated the complete lack of participation in this final attempt to make a new high. This was followed by several high volume consolidation periods and one at low volume.

There was another low-volume rally attempt in early 2001 that is highlighted with another red arrow. And then, at the bottom of the March double-bottom, there was a near miss when the oscillator failed to make it above +10. I have used a dotted green arrow to demonstrate it. In retrospect one might theorize that the lack of volume at that point suggested that the real low lay ahead. The total lack of interest in the rally that followed the March double bottom is illustrated by the dotted red arrow.

In September of last year, after the attacks of 9/11, there was no doubt about the market participation. The highest oscillator level ever accompanied that decline. A series of low-volume highs and high-volume lows continued until just recently, when the last bottom was marked by a very sustained high-volume period as the market collapsed.

Now to the present. The two circled black arrows follow major high-volume bottoms. The first marked a period of consolidation that was followed by the second leg of the rally. I am hoping that the present circled arrow represents the same thing, and that the rally will resume shortly. If it does, pay particular attention to the volume during the second leg. If we can get a high oscillator value during a rising market there will be a chance for a sustained, trending move. In the rally that followed 9/11, the second leg of the rally failed as the final high was reached.

Volume Oscillator April 2000 to the Present Through Tuesday, August 27th

In summary, I have tried to illustrate that rallies accompanied by low volume oscillator moves are likely to reverse the uptrend, and that declines accompanied by high volume oscillator moves are likely to reverse the downtrend. At other times, extremes in the volume oscillator merely point to consolidations in the middle of up or down trends. I will post this chart during critical periods as we go along.

Fred Goodman, CFP, is a fee-only Certified Financial Planner based in Los Angeles. You can send him your questions and comments via email at Fred@MarketMonograph.com. The charts and commentary represent what Fred is thinking about the market and thinking of doing for his own account and for accounts he manages. There is no guarantee that you will profit from trading as discussed herein. You may lose money and Fred assumes no responsibility for what you do or do not do with this information.