Wednesday, September 12, 2012

Main Article: MetaStock Monitor SEPTEMBER-OCTOBER 12

Main Article

How to Find, Track, and Trade with the Smart Money: The Critical Nature of Volume - Part One

Contributed by Jeffrey A. Kilian, Chief Market Strategist and Founder of The Inside Technician

As the market would have it, most participants are wrong in their trading decisions and therefore lose money when they invest or trade. We (as professionals who work in the business every day) know that even though what most dedicated people do is correct.......sometimes they miss the critical ingredient known as "volume".

Volume is the catalyst behind the most explosive and profitable moves in trading any instrument within any market place, and to this day still remains the number one factor that determines the probabilities of future price directional price movement. Volume is the number of shares or contracts traded over a calculated period of time. The result of those volume numbers must then be used to determine the current and future Supply and Demand ratio of what we are analyzing.

A professional trader will focus his or her attention on the Smart Money Volume. This volume is the most important type of volume. It is created by the people who actually move The US Markets and more importantly, The S&P 500 E-Mini futures from one level to another. These are the heavy market participants including off shore hedge funds, US based institutions, major market makers along with specialists on the trading floor who will orchestrate the mechanics behind the new price move, before the general public is aware of what is about to happen.

The effect of what the Smart Money does now creates a new level of supply or demand that was previously non-existent.

Where the ratio of supply and demand changes, so do the opportunities to invest or trade in anticipation to make money (whether long or short). However, without a sufficient amount of accumulated volume incorporated into the analysis of our trading decisions, we leave a reward to risk ratio on the table that is unacceptable. Let's examine the various scenarios where volume, especially a near historical volume spike or accumulated volume levels, plays a critical role in the end result of being on the right side of the markets and ultimately, a winning or losing position. Understanding that our US Markets are highly correlated, and that we must know the current state of our Markets, we begin with a chart of the Dow Jones Industrial Average.

Chart 1

The Basic Scenarios of Volumes True Colors

  • Excessive volume levels occurring at major turning points in the S&P 500 E-Mini Futures Market, stocks, subgroups, parent groups, their assigned Sectors, and the Major Market indexes, gives us the opportunity to get in at the beginning of a change in direction with the potential for profit that no other trading method can offer. For example let's consider the following example:
    • Trader A with 5 years experience finds a real time S&P500 E-Mini futures trade set up from a free or low cost internet program that has several favorable indicator formations and increasing positive volume. Trader A has considerable experience using Technical Analysis and believes there are strong possibilities for short term upside potential price movement. Trader A now analyzes the current state of the overall market and concludes that his/her timing is correct and now decides to trade the 5 E-Mini contracts in isolation. Trader A selected and traded a sub standard trade because of a critical failure to make a relative comparison between the E-mini trade that he/she will make and the "daily price levels in combination with proper volume analysis."

Chart 2 

  • Successive volume spikes or sustained and consistent volume levels allow the trend to continue in the same direction until the trend has exhausted itself.
  • Where short term corrections within an uptrend present themselves, volume will have temporarily dried up and prices will stall and reverse because of the inherent change in the demand/supply ratio- supply has now become clearly in control. This normal correction will last a short period of time until more buying pressure shows up again in the form of volume to act as the engine behind the renewed continuation of the uptrend.
  • The exhaustion of an uptrend is almost always evidenced by a drying up of volume leading to a reversal pattern where the entire process is then repeated but this time leading to a down trend.

Critical Volume Levels Relative to Key Indicator Formations Provide the Confirmation 

  • RELATIVE COMPARISONS of current volume levels to/past levels provide confirmation of Smart Money accumulation or distribution.
  • MACD and Volume relative Comparisons.
  • MONEY FLOW INDEX and Volume relative comparisons.

As traders we have a clear choice in front of us to either choose to trade the candidates that have significantly higher volume levels or not. In choosing average volume level candidates, the statistics will quickly point to substandard trading results. This is a direct result of a lack of serious interest in the security or futures contract for the simple reason there is no real Smart Money buying behind it. No professional trader would make a valid risk to reward calculation before a trade is made without including volume as a serious portion of that equation. 

Chart 3 

The MACD is one of the best indicators to analyze and make trading decisions because of its inherent ability to confirm the trend has now officially changed from one direction to another. Although at times it may lag price movement, its most powerful attribute is the confirmation it will provide us when prices achieve a new pivot point high or low or even a new base formation, and then move up or down from there into a new direction. This provides the confirmation that the probabilities of a new trend are present and we need to start paying serious attention to the trade on our watch list. 

Chart 4 

IF MONEY FLOW is now included in our end of day analysis to determine the validity of the volume that we have now identified; it can provide us with a looking glass effect to determine whether or not that volume is in fact a real institutional and insider buying or not. Can you imagine how your confidence level would change knowing that what you have found has the people behind it that actually move prices from one level to another? This is the skill level that we must invest in and train ourselves to arrive at, now working every day in anticipation of finding, tracking, and trading with these Smart Money market players.

With all the trading platforms available today is it easy to be swayed off course. By taking the necessary time to educate yourself on the most important aspects of professional trading it becomes second nature to spot turning points leading to the possibilities of a new trend, the tracking of a trend and most importantly a futures contract or a stock that is waiting for a substantial upside move. The critical nature of volume in this case being "a historical volume spike or accumulated volume level identified at precisely the right time" guides you to the true high probability trade vs. Trader A who will continue to make substandard trades and never know the inner workings of what really moves prices from one direction to another. The obvious question to ask yourself now becomes have you been trading on the A side or the B side?

Waiting and trading with the correct volume level will put the risk/reward ratio greatly in your favor. Your best positional advantage as a trader or investor is patience. It is always better to wait until a significant or even historical volume level arrives before putting on a serious position. This basic tenant has applied to the majority of the biggest moves in the history of the securities market and still stands today as the mark of a professional trader. Volume is our trading edge and puts it all in our favor. Once we learn how to employ its edge, we cross over to an entirely different level of trading and investing.

You can learn more and subscribe to "THE NIGHTLY MARKET INTELLIGENCE REPORT"™ by clicking here.

About Jeffrey Kilian

Jeff Kilian is a 13-year veteran trader/technical analyst who uses only technical analysis to make all his own trading decisions. His communication skills are what clearly set him apart from others in the educational side of the securities business, allowing him to teach in a clear and easily-understood manner.

By following a structured, learnable, and repeatable process, his clients learn in a fraction of the time what it takes to become a real life professional and profitable trader.

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