Inside a Volume Divergence

Nov 8, 2008: 12:02 PM CST

Much has been made about the recent rally into resistance on lower volume, and the subsequent sharp correction following Tuesday’s election.  Let’s step inside this situation for clues on how volume could have helped you anticipate a reversal… or at least suspected that ‘things weren’t quite right’ with the recent rally.

Let’s step inside the Dow Jones Index on the 30 min chart:

Price began a large momentum burst on October 28 which was a counter-trend rally that lasted until November 4th, taking the DIA from $83 to $96 – a large jump – in a matter of days.

What was volume saying to us at that time?  Volume – participation – was NOT confirming these higher prices, as you can see each day’s activity slowly trailed off until reaching a low on November 3rd, one day before the swing high in price appeared.  A negative momentum divergence also accompanied higher prices, which was a further non-confirmation of bullish strength.

As price broke the 20 and then 50 period Exponential Moving Averages, volume began to trend higher as price began its down-swing to the $87 level.  The green arrow represents incresing volume on declining prices, which serves as a ‘confirmation,’ or more specifically, volume was increasing in the direction of the price movement.

A “non-confirmation” by volume occurs when volume is declining in the direction of price movement.  It’s not so much an “up or down” thing, but moreso “is the volume trend rising and falling, and what might that say about the possible future direction?”

Generally, in a strong up-trend, we would expect volume to be rising as well as price travels higher which indicates that more people/funds are participating, increasing demand and pushing price higher.  We would like to see volume decline on sell-offs (counter-swings down) because this would serve as a “non-confirmation” of lower prices, or that people were willing to hold shares and not actively distribute them.

The same is true in a down-trend, in terms of we want to see the volume trend rising as price is making new lows, which serves as a confirmation of these new lows and then trend lower as price rallies in a counter-trend fashion, as the above example shows.

In short, we expect “Volume Goes with the Trend” to the be default expectation, though we’re not always granted this luxury.

The take-away from this example is that price was structurally in a counter-trend rally up on subsequently declining volume, combined with a negative momentum divergence.  That, combined with other analysis, was reason to doubt the short-term sustainability of the higher prices, and caused a higher probability of a downward price move coming.

Volume is only a piece of the puzzle, and by no means can any one piece give an accurate picture in isolation.

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  • Vector

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  • KingBacami990

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  • Suraj,

    It's actually just changing the default MACD indicator in StockCharts to 3, 10, 16 (input in the boxes). This creates the "3/10 Oscillator".

    In essence, it's the difference between a 3 and 10 period EMA (black line) which is then smoothed by 16 periods (red line).

    Thank you for the question and for reading!

  • Suraj


    I've been an avid reader ever since I came. What indicator are you using for the lower subchart to pickup the divergences?



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