Chapter Two

Why Volume?
The key is having more information than the other guy – then analyzing it
right and using it rationally.
Warren Buffett (1930-)

This is the article that I wrote for Stocks and Commodities magazine many
years ago. I called it the Parable of Uncle Joe. I have made some minor
changes, but the essence of the article remains, as originally published.
One day after a particularly bad trading day, my Uncle Joe took me aside
and consoled me with some hard facts about how the markets really work.
And he told me this story.

You see, my Uncle Joe owns a unique company, which has given him an
insider's perspective on how stock price movement is managed.

His company, Widgets & Co., is the only company in the state that distributes
widgets, and it does so under license from the government. It has been buying
and selling its unique widgets for many years. These widgets have an
intrinsic value, they never break, and the number in circulation at any one
time is much the same.

Being a reasonably clever man with many years of experience managing his
business, my uncle soon realised that just buying and selling his widgets to
customers was, in fact, rather dull. The amount of money he made each time
he bought and sold was quite small, and the number of transactions per day
was also low.

In addition, he also had all the running expenses of his office, his warehouse
and his staff. Something would have to be done.

Having given the problem some thought, he wondered what would happen if
he mentioned to a neighbour that widgets could soon be in short supply. He
knew his neighbour was a terrible gossip, so this was almost as effective as
putting an advertisement in the local paper. He also knew from checking his
warehouse, that he had enough stock to meet any increased demand should
his plan be successful.

The following day he met his neighbour outside, and casually mentioned his
concerns, begging the man to keep it to himself. His neighbour assured him
that he wouldn't breathe a word; his lips were sealed.

Several days passed and widget sales remained flat.

However, after a week or so, sales started to pick up with more customers
coming to the warehouse and buying in larger quantities. It seemed his plan
was starting to work and everyone was happy. His customers were happy as
they knew that widgets would soon be in short supply, and so their value
would increase. Uncle Joe was happy because he was selling more widgets,
and making more money every day.

Then he started to think.

With everyone buying his widgets, what would happen if he raised his prices?
After all, he was the only supplier and demand was high at the moment.

The following day he announced a price increase, but still believing there
would soon be a widget shortage, his customers continued to buy in ever
larger quantities!

As the weeks passed he gradually increased his prices higher and higher, but
still the buying continued. A few of his more astute customers started to sell
their widgets back to him, taking their profits, but Uncle Joe didn't mind as
he still had plenty of willing buyers.

This was all good news for Uncle Joe, until one day, he suddenly realised
with some alarm that his warehouse was now looking very empty indeed. He
also started to notice that the volume of sales each day was decreasing. He
decided to keep moving prices up, so everyone would think that the situation
was unchanged.

But now he had a new problem. His original plan had been too successful.
How on earth was he going to persuade all his customers to sell widgets back
to him, so that he could continue in business?

He pondered this problem for several days with no clear solution. Then, quite
by chance, he met his neighbour again in town. The man drew him to one
side and inquired whether the rumour he had heard was true? Inquiring into
what that rumour might be, Uncle Joe learned that his neighbour had heard
that another, much bigger widget distribution company was setting up
business in the area.

Being clever, Uncle Joe realised that providence had given him the answer
on a plate. Appearing crestfallen, he admitted that the rumour was true, and
that his business would suffer badly. More importantly, widget values were
likely to drop dramatically in price.

As they parted company, Uncle Joe chuckled to himself at having such good
fortune, and such a helpful gossip for a neighbour.

Within days he had queues of customers outside his warehouse doors,

begging him to buy back their widgets. With so many people selling, he
dropped his prices quickly, making people even more desperate to sell before
their widgets became worthless!

As the prices fell further, more and more people cracked under the pressure.
Uncle Joe was now buying back an enormous volume of widgets. After
several weeks the panic selling was over, as few people had been brave
enough to hold out under the pressure.

Uncle Joe could now start to sell widgets again at their old levels from his
warehouse full of stock. He didn't mind if it was quiet for a few months, as he
has made a great deal of money very quickly. He could afford to take it easy.
His overhead expenses were covered and he could even pay his staff a
healthy bonus. Everyone soon forgot how or where the rumours had started
and life returned to normal.

Normal that is until Uncle Joe started thinking one day. I wonder if we could
do that again?
Uncle Joe's story is of course fiction. It was written before I discovered the
work of Richard Ney, but it is interesting that we both use the same analogy
to describe the insiders, the specialists, or what most people call the market
makers.
It is my view, (and of Richard Ney) that this is one of the great ironies of the
financial markets. Whilst insider dealing by individuals on the outside is
punished with long prison sentences and heavy fines, those on the inside are
actively encouraged and licensed to do so. The problem for the exchanges
and governments is that without the market makers, who are the wholesalers
of the market and provide a guarantee of execution of the stock, the market
would cease to function. When we buy or sell in the cash market, our order
will always be filled. This is the role of the market maker. They have no
choice. It is their remit to fulfil all orders, both buying and selling and
managing their order books, or their inventory accordingly.
As Ney said himself, the market makers are wholesalers, nothing more,
nothing less. They are professional traders. They are licensed and regulated
and have been approved to 'make a market' in the shares you wish to buy and
sell. They are usually large international banking organisations, generally
with thousands or tens of thousands of employees worldwide.
Some of them will be household names, others you will never have heard of,
but they all have one thing in common - they make vast amounts of money.
What places the market maker in such a unique position, is their ability to see
both sides of the market. In other words, the supply and demand. The
inventory position if you like.
Just like Uncle Joe, they also have another huge advantage which is to be
able to set their prices accordingly. Now, I don't want you to run away with
the idea that the entire stock market is rigged. It isn't. No single market maker
could achieve this on their own
However, you do need to understand how they use windows of opportunity,
and a variety of trading conditions to manipulate prices. They will use any,
and every piece of news to move the prices, whether relevant or not. Have
you ever wondered why markets move fast on world events which have no
bearing. Why markets move lower on good news, and higher on bad news?
The above explanation is a vast over simplification but the principle remains
true. All the major exchanges such as the NYSE, AMEX and the NASDAQ
have specialists who act as market makers. These include firms such as
Barclays plc (BARC) and Getco LLC that oversee the trading in shares and
what is often referred to as The Big Board (shades of Jesse Livermore,
perhaps). According to Bloomberg Business in 2012 ‘exchanges are
experimenting with ways of inducing market makers to quote more
aggressively to attract volume’. In addition, in the same article the US
exchanges are very keen to increase the number of companies who can act as
market makers. But, other than this, not much has changed since the days of
Richard Ney.
Do these companies then work together? Of course they do! It goes without
saying. Do they work in an overt way? No. What they will all see, is the
balance of supply and demand in general across the markets and specifically
in their own stocks. If the specialists are all in a general state of over supply,
and a news story provides the opportunity to sell, then the market markers
will all act pretty much in unison, as their warehouses will all be in much the
same state. It really is common sense once you start to think about the
markets in this way.
On the London Stock Exchange there are official market makers for many
securities (but not for shares in the largest and most heavily traded
companies, which instead use an electronic automated system called SETS).
However, you might ask why I have spent so much time explaining what
these companies do, when actually you never see them at all. The answer is
very simple. As the 'licensed insiders', they sit in the middle of the market,
looking at both sides of the market. They will know precisely the balance of
supply and demand at any one time. Naturally this information will never be
available to you, and if you were in their position, you would probably take
advantage in the same way.
The only tool we have at our disposal to fight back, is volume. We can argue
about the rights and wrongs of the situation, but when you are trading and
investing in stocks, market makers are a fact of life. Just accept it, and move
on.
Volume is far from perfect. The market makers have even learnt over the
decades how to avoid reporting large movements in stock, which are often
reported in after hours trading. However, it is the best tool we have with
which to see ' inside the market'
Volume applies to all markets and is equally valuable, whether there is
market manipulation or not. Volume in the futures market, which is the
purest form of buying and selling reveals when the market is running out of
steam. It reveals whether buying interest is rising or falling on a daily basis. It
reveals all the subtleties of pull backs and reversals on tick charts and time
charts from minutes to hours. Volume is the fuel that drives the market.
Volume reveals when the major operators are moving in and out of the
market. Without volume, nothing moves, and if it does move and the volume
is not in agreement, then there is something wrong, and an alarm bell rings!
For example, if the market is bullish and the futures price is rising on strong
and rising volume, then this is instantly telling us that the price action is
being validated by the associated volume. The major operators are buying
into the move. Equally, if the market is falling and the volume is rising, then
once again volume is validating price. It really is that simple. These
principles apply whatever the market, whether it is bonds, interest rates,
indices, commodities or currencies. What you will discover in this book is
that the analysis of price and volume applies to every market, manipulated or
otherwise. In the manipulated cash markets of stocks, it provides you with the
ultimate weapon to avoid being suckered in by the market makers.
In the futures markets, it gives you the ultimate weapon to validate price, and
to reveal the true market sentiment of buyers and sellers and to take action as
the reversals in trend are signalled using volume. Here, we are following the
major operators who will have the inside view of the market.
In the spot forex market we have a different problem. There is no true volume
reported. Even if there were, would this be shown as trade size, or 'amounts
of currency' being exchanged. Fortunately however, we do have an answer to
volume in the world's largest financial market, and it’s called tick volume.
However, tick volume is not perfect, nothing is in trading. First, the tick
volumes on one platform will vary from the tick volumes on another, since
tick data will be provided through the platform of an online broker. Second,
the quality of the data will depend on several factors, not least whether the
broker is subscribed directly to the interbank liquidity pool directly using one
of the expensive wholesale feeds. Nevertheless, a quality FX broker will
normally provide a quality feed.
But, is tick data valid as a proxy for volume?
The short answer is yes, and various studies over the years have shown that
tick data as a proxy for 'volume' is 90% representative in terms of the true
'activity' in the market. After all, volume is really activity, and in this sense
can be reflected in price, since tick data is simply changes in price. So, if the
price is changing fast, then does this mean that we have significant activity in
the market? In my opinion the answer is yes. To prove this point, we only
need to watch a tick chart prior to, and just after a significant news release.
Take the monthly Non Farm Payroll, which every forex trader knows and
loves! Assume we are watching a 233 tick chart. Prior to the release each 233
tick bar may be taking a few minutes to form. During the release and
immediately after, each bar is forming in seconds, appearing as if being fired
onto the screen using a machine gun! A chart that has taken an hour to fill
with bars, is now a full frame within minutes.
This is activity, pure and simple, which in turn we can assume is
representative of volume. There will always be market manipulation in the
spot forex market. In many ways it is the most widely manipulated of all. We
only have to consider the currency wars as evidence of this, but as traders,
tick volume is what we have, and tick volume is what we use. Whilst it isn't
perfect, I can guarantee you one thing. You will be considerably more
successful using it, than not, and you will see why, once we start to look at
the charts themselves across all the various markets.
If you are still not convinced? Let me give you an analogy, not perfect I
accept, but which I hope will help.
Imagine that you are at auction, and suppose for argument’s sake that it’s an
auction for furniture. It is a cold, wet and miserable day in the middle of
winter, and the auction room is in a small provincial town. The auction room
is almost empty, with few buyers in the room. The auctioneer details the next
item, an antique piece of furniture and starts the bidding with his opening
price. After a short pause, a bid is made from the room, but despite further
efforts to raise the bidding, the auctioneer finally brings the hammer down,
selling the item at the opening bid.
Now imagine the same item being sold in a different scenario. This time, the
same item is being sold, but the auction house is in a large capital city, it is
the middle of summer and the auction room is full. The auctioneer details the
next piece which is our antique furniture, and opens the bidding with a price.
The price moves quickly higher, with bidders signalling interest in the
auction room, and phone bidders also joining in. Eventually the bidding
slows and the item is sold.
In the first example, the price changed only once, representing a lack of
interest, and in our terms a lack of bidders in the room, in other words
volume. In the second example the price changed several times and quickly
with the price action reflecting interest, activity and bidders in the room. In
other words volume.
In other words, the linkage between activity and price is perfectly valid.
Therefore, as far as I’m concerned, using tick data as a proxy for volume data
in the forex market is equally valid. Activity and volume go hand in hand,
and I hope that the above analogy, simple and imperfect as it is, will convince
you too.
The above simple analogy also highlights three other important points about
volume.
The first is this. All volume is relative. Suppose for example this had been
our first visit to this particular auction room. Is the activity witnessed
average, above average or below average. We would not be able to say, since
we have no yardstick by which to judge. If we were a regular visitor, then we
could judge instantly whether there were more or less attendees than usual,
and make a judgement on likely bidding, as a result.
This is what makes volume such a powerful indicator. As humans we have
the ability to judge relative sizes and heights extremely quickly, and it is the
relative aspect of volume which gives it such power. Unlike the tape readers
we have a chart, which gives us an instant picture of the relative volume bars,
whether on an ultra fast tick chart, an intra day time chart, or longer term
investing chart. It is the relationship in relative terms which is important.
The second point is that volume without price is meaningless. Imagine an
auction room with no bidding. Remove the price from the chart, and we
simply have volume bars. Volume on its own simply reveals interest, but that
interest is just that, without the associated price action. It is only when
volume and price combine that we have the chemical reaction which creates
the explosive power of Volume Price Analysis.
Third and last, time is a key component. Suppose in our auction room,
instead of the bidding lasting a few minutes, it had lasted a few hours ( if
allowed!). What would this tell us then? That the interest in the item was
subdued to say the least. Hardly the frenetic interest of a bidding war.
To use a water analogy. Imagine that we have a hosepipe with a sprinkler
attached. The water is the price action and the sprinkler is our 'volume'
control. If the sprinkler is left open, the water will continue to leave the pipe
with no great force, simply falling from the end of the pipe. However, as soon
as we start to close our sprinkler valve, pressure increases and the water
travels further. We have the same amount of water leaving the pipe, but
through a reduced aperture. Time has now become a factor, as the same
amount of water is attempting to leave the pipe in the same amount of time,
but pressure has increased.
It is the same with the market.
However, let me be provocative for a moment, and borrow a quote from
Richard Wyckoff himself who famously said :
“….trading and investing is like any other pursuit—the longer you stay at it
the more technique you acquire, and anybody who thinks he knows of a short
cut that will not involve “sweat of the brow” is sadly mistaken”

Whilst this sentiment could be applied to almost any endeavour in life, it is

particularly relevant in the study of price and volume.
As you are probably aware, or will not doubt find out when you begin
trading, there are several free 'volume' indicators, and many proprietary
systems you can buy. Whether free or paid, all have one thing in common.
They have neither the capacity nor intellect to analyse the price volume
relationship correctly in my view, for the simple reason, that trading is an art,
not a science.
When I finished my two weeks with Albert, I then spent the next 6 months
just studying charts, and learning to interpret the price and volume
relationship. I would sit with my live feed and my two monitors, one for the
cash market and the other for the equivalent futures market, watching every
price bar and the associated volume and using my knowledge to interpret
future market behaviour. This may not be what you want to read. And some
of you may be horrified at how labour intensive this all sounds.
However, just like Wyckoff, I also believe there are no short cuts to success.
Technical analysis, in all its aspects is an art, and interpreting the volume
price relationship is no different. It takes time to learn, and time to be quick
in your analysis. However, just like the tape readers of the past, once
mastered is a powerful skill.
The technique is a subjective one, requiring discretionary decision making. It
is not, and never will be, one that lends itself to automation. If it were, then
this book would simply be more fuel for the fire.
Finally, (and I hope you are still reading and have not been put off by the
above statements), one further aspect of volume is whose perspective are we
using when we talk about buying and selling. Are we talking from a
wholesalers perspective or from the retail perspective. So, let me explain.
As investors or speculators the whole raison d'etre for studying volume is to
see what the insiders, the specialists are doing. For the simple reason that
whatever they are doing, we want to follow and do as well! The assumption
being, implied or otherwise, is that they are likely to have a much better idea
of where the market is heading. This is not an unreasonable assumption to
make.
So, when the market has moved sharply lower in a price waterfall and a
bearish trend, supported by masses of volume, this is a buying climax. It is
the wholesalers who are buying and the retail traders who are panic selling. A
buying climax for us represents an opportunity.
Likewise, at the top of a bull trend, where we see sustained high volumes,
then this is a selling climax. The wholesalers are selling to the retail traders
and investors who are buying on the expectation of the market going to the
moon!
So remember, when I write about volume throughout the remainder of this
book, buying and selling is always from a wholesalers perspective as this is
the order flow that we ALWAYS want to follow.
Now in the next chapter we're going to move on to consider the other side of
the equation, which is price.