The Basics of Chart Patterns - Volume in Trends

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Volume in Trends

From our last section we know that in theory volume should follow a trend. Once again, this means that in an uptrend volume should expand on rallies and contract on declines. In a downtrend volume should expand on declines and contract on rallies. For the purposes of this section we will assume these rules apply for healthy bullish and bearish trends.

But what happens when a stock advances and volume contracts -- or a stock falters and volume expands? It is not supposed to happen but when it does the result is almost always a sharp reversal.

Rallies With Contracting Volume

Consider this example. In the winter of 1999 data storage stocks were a momentum investors' dream. The news flow was positive and analysts were falling over one another to make a name for themselves by finding the next EMC Corp. (EMC). Atop the momentum mountain was Qlogic (QLGC).

Qlogic had been mired in a consolidation pattern through early January and February 2000 before the stock had a volume breakout at $92. From that point the stock began a parabolic advance that saw the issue more than double in price in just one month! It was a momentum investors' dream come true -- there was just one problem, as the stock rallied to one new high after another amid buy recommendations and better than expected earnings reports, volume was slowing. In fact, all through the rally, volume did not approach the high made in early January when the initial consolidation began. When stocks rally to new highs amid slow or progressively weak volume technicians argue that they enter the distribution phase -- the phase where the "smart money" begins selling profitable long positions amid continued good news. By April 15, just another month later, the stock had fallen from better than $200 per share to just $60. The weak volume rally laid the foundation for a spectacular decline. Of course there is a moral here; Beware weak volume rallies amid good news.

Declines With Expanding Volume

Now let's jump ahead one year. We are still looking at Qlogic but in the late winter of 2000 the data storage concern was a very different stock. Ravaged by an ongoing bear market for technology stocks and a steady stream of earnings warnings, Qlogic shares had fallen from favor with Wall Street analysts. Those that once forecast fundamental splendor now talked regularly of impending doom.

In the winter of 2000 Qlogic had fallen far from favor but the stock did begin the process of consolidating its losses during January 2001 and early February. The stock rallied from $60 to $98 during this time frame on better than average volume only to falter once again in the middle of February after an earnings warning from EMC Corp. (EMC). Qlogic, and most other data storage issues collapsed and by early April the stock had fallen to less than $20. It was a short sellers' dream -- there was just one problem, volume had contracted at each stage of the march to new lows. When stocks decline to new lows amid slow or progressively weak volume technicians argue that they enter the accumulation phase -- the phase where the smart money begins adding new positions for longer term gains. During the span of the next six weeks Qlogic shares had more than tripled on increased volume. Of course the lesson is that one needs to be very careful about selling into weak volume declines amid bad news.

Now that we know what is supposed to happen to volume in trends (and what happens when reality does not follow theory) let's take a look at volume in a very different way, consolidations.

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