<s> TRADINGWITHEQUIVOLUME
ByRICHARD W. ARMS, JR.
www.ArmsInsider.comcopyright 2001, Richard W. Arms, Jr.
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Table of ContentsIntroduction .........................................................................................3Technical Analysis...............................................................................7Equivolume Charting.........................................................................9Turning Points ...................................................................................14Buying the Breakouts .......................................................................19Buying Continuation Patterns........................................................22When to Sell .......................................................................................26Selling Short .......................................................................................29Support and Resistance ...................................................................32Trendlines and Channels.................................................................35Gaps.....................................................................................................37Conclusions........................................................................................39
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INTRODUCTIONYES!I just sold a stock for $23 that I bought last week for $18. What a high! That is thepleasure of being a trader, being right. Taking a profit is great, but the money is not asimportant as the success. I think the best trader is the one who only uses the money tokeep score. He treats trading as a challenge.In the pages that follow we are going to be looking at some unique methods of analysisthat can help to make trading more successful and therefore more fun. When I saytraders I am thinking primarily of those who buy individual stocks and hold them for aperiod of days, or at most a few weeks. All the examples we look at will be concernedwith that time frame. That is not to say the methodology is not applicable to other timeframes, it is. But our emphasis will be on short term trading. If we can think of the market movements as consisting of tides, waves and ripples, we are going to be looking atthe waves. Day traders may want to apply the ideas to the ripples. Long-terminvestors can look at the larger picture and use the methods to take advantage of thelarge tidal movements. In addition, we will not be looking at options trading, just theunderlying stocks. But anyone wanting to trade options must be able to understandwhere the underlying stock appears to be headed. Every principle in the pages that follow is a tool for the options trader as well.When I first became a retail stockbroker, forty years ago, one of the first admonitionsfrom the firm was that we were never to equate investing in stock with gambling. Evenwhen a client was trading on a short-term basis, it was a no-no to suggest that it was aform of wagering. We were well above acting as though we were operating a Las Vegascasino. Moreover, it was pointed out, when you put your money on a roulette table or ahorse, it either won and made money or it lost and you lost all your money. Withstocks, there was residual value. You might sell at a lower price than where youbought, but you would get back some of your money. Therefore, it was investing, notgambling. Of course, if you were in a margin account, it might take a lot of it in a hurry.And if you did not act quickly enough and the market acted unusually, you could getwiped out just about as quickly as at a blackjack table. On the other hand, the rightstock in the right market was not very different than the right horse in the KentuckyDerby. But still, it was not to be thought of as gambling.
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In the pages that follow we are going to put that admonition aside, and realize that ouronly aim in the market is to buy at a lower price than we sell. The desire is to makemoney. The vehicle we will use in trying to make money is stock. Any stock that goesup when we are long, or down when we are short, is a good stock. I often say, when Iam making a speech, that it would be a lot better if stocks did not have names, justnumbers. Then we would not become emotionally attached to them. If it was juststock 175 instead of Compaq Computer, we would be less likely to make bad decisionsbecause we “liked” the company. It is that sort of detached objectivity that we will bestriving for in the pages that follow. True, it is not gambling, in that you are buyingsomething of value; ownership in a corporation. But if one is adopting a short-term andaggressive attitude, that objective is far overshadowed by the fact that it is only a vehicle used to try to make money. Moreover, we are going to want to be as willing to sellshort as we are to buy. Selling short is certainly not designed to participate in“Corporate America”.Understand, we are not talking about the building of a long-term portfolio of stocks.That is an entirely different approach, and has been the basis of several of my earlierbooks. We are, in the pages that follow, going to be talking about the aggressive buyingand selling of stocks. We are going to look at the short side as well as the long side ofthe market. We are not going to be talking about “owning a piece of CorporateAmerica”, we are going to be talking about buying and selling stocks because we thinkthe price is going to change in our favor.But there is another factor that makes it far different than a trip to Vegas. When we pullthe lever on a slot machine or place a bet on red at the roulette wheel the result is entirely a function of chance. We have absolutely no control over the outcome. Intelligenceplays no part beyond that point. Perhaps we can know the odds well enough to placeour bets where we have the best chance of winning, but we cannot play any part inwhere the ball drops in the slot or how the wheels turn in the machine. In the stockmarket we can be rewarded for being smart. We can make good decisions and swingthe odds in our favor.In addition, at the casino the house always wins. The odds are such that in the long runthe gamblers are always the losers. It is not even a zero-sum situation. It is an automatic losing position, on average. In the market, if stocks are in a long-term advance, thebuyers can all be winners, on average. In bear markets all the short sellers can be winners. Of course, there is still a cost of buying and selling, which puts a part of everyArmsInsider.com
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investment in the pocket of a broker. But it is not the handicap it once was.Commissions are now so low as to be of little concern. In a sideways market it is notquite a zero-sum game, but it is close to it.As we go along we will be looking at a methodology that is designed to swing the oddsin our favor. We will be combining price and volume into usable information. It is amethodology that helps to shield us from irrational emotional decisions. We will beconcerned with the emotionalism of others, and attempting to recognize times when aswing in emotions is presenting an opportunity to make money. The interplay of priceand volume will help to tell us what others are doing, and allow us to take advantageof that knowledge.Interestingly, all of the methodology we will consider in the pages that follow havetheir place in conservative long-term investing also. In fact, my prior books have concentrated on that aspect of the market. We are going to be talking about the delicate balance between fear and greed that moves prices, and those forces are in control on thelong term as well as the short term. For the purposes of this write-up our time framewill be days and weeks, but the same methods are effective as we move up or down thetime scale. An Equivolume chart that is posted minute by minute during a trading daycontains all the same characteristics as a chart posted on a daily or a weekly basis. Wewill be studying moves that develop over a few days, because that is also the focus ofmy website, ArmsInsider.com, which offers stock recommendations and is an adjunct tothis book. A trader who wants to follow and use our recommendations needs to befamiliar with the reasoning that leads to those suggestions.We are living in a wonderful era for investors. Technology has made it possible, asnever before, for a diligent trader to be successful. With the speed of computers and ofcommunications, everyone has an opportunity to participate on equal footing. When Ifirst invented the Arms Index (some people still call it TRIN) in 1967, I had to calculateit on a slide rule. Now it is calculated for me second by second and appears on almostevery quotation device. It crosses the tape every few minutes on CNBC. When I firstdeveloped Equivolume charting, every chart had to be drawn by hand. Now there arecomputer programs that do it all, and do it well. I am able to follow thousands ofstocks on a daily basis, searching for opportunities. Thirty years ago I hand-drewcharts of a few dozen stocks, and when they went off the top or bottom of the page Ihad to start over. When the volume characteristics changed I had to rescale them andthrow the old charts away. Today the computer recalculates and rescales the charts soArmsInsider.com
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they always fit the page. Facts, rumors, advice and opinions flash across the screen onthe Internet. Geography has become meaningless to the trader. Moreover, the intensecompetition of the marketplace has brought commission rates down so low that theyare close to negligible. The trader no longer needs to be concerned with the transactioncosts. If a stock is not acting right it can be sold and replaced instantly and almost without cost. What used to take a number of phone calls to a broker, wires to New York,calls back with confirmations and waiting days for balances, are all now activated bythe click of a mouse button. The trading mechanics have become so efficient that noone need be disadvantaged because of geography or cost.Now, with decimalization, spreads have contracted even further. There are now 100possible steps in single point of range, instead of just eight a few years ago.All this is good, in that the small trader is on an even footing with the big trader. It isalso a curse, though. There is so much information, and so many rumors, and so manyopinions, that it can lead to confusion and indecision. Modern communications haveled to an overload of data. We will, in the pages that follow, try to cut through thatmorass, and concentrate on the few factors that can lead to extraordinary profits.
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TECHNICAL ANALYSISThis book is about technical analysis. Moreover, it is about one particular type of technical analysis. You will not see anything about earnings, or dividends or cash flows.Nowhere will we mention management or products or competition or sales. Search allyou want but you won’t find another mention of price to earnings ratios. All we aregoing to be concerned with is price and volume. We are going to look at the past, andtry to anticipate the future, and we are going to do so without ever looking at a singlefundamental factor.This is not because of laziness; it is because of our need to be realistic and objective.The stock market determines the price of a stock, and the volume of the trading represents the amount of interest in that determination. That determination is based uponall the factors mentioned above; the fundamental factors I will not repeat because I saidyou would not ever see them again in this book. But the fundamentals do not directlydetermine price. First they have to be passed through a very critical filter, which is theemotionalism of the marketplace. The fundamentals are only as important or unimportant as the emphasis placed on them by the millions of minds studying them. We haveall seen a stock go down on a good piece of news or up on news that looks terrible, andwe have shaken our heads in disbelief. That was because we were trying to predictwhat other people would think of that news. But the market is never wrong. It isreflecting exactly what the consensus really is. The market is a very efficient and accurate reflection of the facts, but only after they have been analyzed and then reacted to inan emotional manner. In the final analysis, the price of a stock and its volume are areflection of a delicate balance between fear and greed. That balance is influenced bythe underlying fundamentals, but is not a direct representation of those fundamentals.In using technical analysis we are deciding to study the output of those emotionalresponses, rather than try to second-guess what they may be, based on our limitedknowledge of the “facts”. When we look at price and volume, we are looking at all thefacts; they have been interpreted for us, and translated into fear or greed. It is not laziness that keeps a technician from looking at the fundamental data, is the knowledgethat everything that is known about a stock has been already taken into account, and itis publicly available in the form or the price of the stock and the amount of stock that ischanging hands.
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The way in which the methods that follow are different than other technical analysismethods is the great dependence upon, and emphasis of, volume. It is, I believe, ofparamount importance, yet it is often ignored. Many traders do not even follow thenumber of shares being traded, relying wholly upon price movement to make theirdecisions. Yet, without knowing the volume one has no idea of how much conviction isinvolved in a move. It is like buying a car without looking under the hood. One needsto know if that car has enough power to get over the hills. It can have a beautiful paintjob, wonderful upholstery, great tires, but it is useless if it doesn’t have an adequatemotor. Volume is the motor of the marketplace. We are going to be looking under thehood of each stock we trade, and seeing whether the power is there or not. To do thatwe are going to use my unique charting method called Equivolume.
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EQUIVOLUME CHARTINGShown below is the type of chart we are all familiar with; a bar chart. In this case eachvertical line represents one day of trading. The top of the line represents the high of theday and the bottom of the line represents the low of the day. The little horizontal line isthe level at which the stock closed on that day.93
American Express (80.44, 80.75, 78.38, 79.06)
92919089888786858483828180797877767574737271
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Across the bottom of the chart is a histogram that represents the volume. By tracingupward we can equate the volume for each day with the price action on the same day,but it is difficult to know precisely which volume applies to which price in every case.When I first thought of Equivolume as an alternative to bar charts I had already becomeaware of the importance of volume. I knew that it was necessary to see whether volume was heavy or light as a stock moved through an old level of resistance or support.I knew that volume tended to become heavy, and price spread tended to shrink, atimportant tops. I had become aware that large price swings on heavy volume weretypical of climactic bottoms. I was intensely aware of volume, because it was volumethat was at the foundation of my, by then already popular, Arms Index. It bothered methat volume tended to be relegated to a secondary significance, or even completelyignored at times. I felt that volume needed to be made a full partner with price if onewas to understand the underlying dynamics of price movement.
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When it came to me, driving home one afternoon, it was absurdly simple. All that wasnecessary was to combine the two pieces of information into a single posting. I wouldmove volume off the lower margin of the chart and incorporate it in the price posting.Each day would appear as a rectangle, with the width being the volume. The top of thebox, as with a bar chart, would be the high of the day, and the bottom of the box wouldbe the low of the day. All I would be doing would be spreading each bar chart linesideways into a rectangle, as a function of the number of shares traded. The resultswere fantastic! Each posting started to give a much more complete picture of the trading. I found that each box was giving a concise picture of supply and demand for thatstock on that day. Shown below is an Equivolume chart of the same stock over thesame period we were looking at above.American Express (80.44, 80.75, 78.38, 79.06)
f
93.092.592.091.591.090.590.089.589.088.588.087.587.086.586.085.585.084.584.083.583.082.582.081.581.080.580.079.579.078.578.077.577.076.576.075.575.074.574.073.573.072.572.071.571.070.5
h
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The first thing that becomes immediately apparent on this chart is that all days are notthe same. Compare the box marked “a” with the box market “b”. Each represents asingle day of trading but one is tall and wide while the other is short and narrow.Obviously, “a” was a very significant day. There was a wide trading range and heavyvolume. Box “b” was a far less meaningful day. Volume was light and there was notmuch price movement. Box “h” was short but fairly wide, indicating volume but lackof price movement. It was suggesting the stock was encountering resistance after thelight volume rally. Box “i” was tall, but on good volume, and was saying that the stock
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was moving downward with vigor. The shape and size of each box has a story to tell.Let us go through all the indicated boxes on this chart, and see what they were tellingus.a. A heavy volume reversal day. This looked like the culmination of the decline.Heavy volume and a wide spread are typical of the final washout of a drop.b. A light volume rally off the low. The lack of volume makes it far from convincing.c. Here we are seeing a rally with better volume. It suggests that the low was tested,and that the rally might carry further.d. Notice the very light volume on this pullback. It now looks as though volume iscoming in on the upside and drying up on the downside. That is a very bullishsign.e. On the next day volume explodes to the upside, penetrating the resistance we sawat “b” and saying the stock is headed higher.f. After a big advance over the prior two weeks volume remains heavy but the rangecontracts. Perhaps the stock is encountering resistance after such a sudden rise.g. This is ominous. Heavy volume to the downside and a wide trading range. If wewere to insert a trendline along the bottoms of the rise, this drop would penetrateit. But the narrowness of the top suggests it is not likely to go lower until someattempt to rally is made.h. The stock rallies, but the move lacks volume. It looks like a lighter volume test ofthe heavy volume top at “f”.i. The decline resumes, on heavier volume, and support is penetrated decisively.j. The decline continues.This is a fairly typical Equivolume chart, posted on a daily basis. By going to weeklypostings or three-day postings a longer-term outlook can be achieved. Very aggressiveintraday traders might go to hourly charts or even five-minute charts. On our website,all of the Equivolume charts are daily, with the aim of taking advantage of price moveslasting a few days or, at most, weeks. But in any time frame, the signals given by theprice to volume relationship are similar. On longer-term charts they tend to be moremuted and on very short-term postings they tend to be more erratic. But the rules arethe same. The shape of each box and its size tells us how easy or hard it is for price tomove in a given direction.There are other tools that are used as well. The chart below has the appearance of thetypical chart published on our website. On it you will see a number of other lines thatneed some explanation. But first look at the boxes on this stock, as we did on the priorArmsInsider.com
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example. Notice particularly the two boxes at the low. They are very wide and short.They denote extremely heavy volume in a narrow trading range, and indicate a stronglevel of support.0.60.50.40.30.20.10.0-0.1-0.2-0.3-0.4-0.5-0.6-0.7-0.8
Ease of Movement (0.5472), Ease of Movement (0.2019)
ADV TISSUE SCI (5.500, 4.375, 5.125)8.07.57.06.56.05.55.04.54.03.53.0
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Followed by the two up boxes that are tall for their width, but still are on fairly heavyvolume, we have a signal the stock is turning up, and it is time to buy. Notice also thelast posting on the chart. The stock has moved through an old area of resistance withincreasing volume and a widening range. That is a very bullish signal. As we will see alittle later, a light volume pullback is likely before going higher. Often we will look forthat pullback before buying.Superimposed on the Equivolume postings are two lines, one red and the other blue.They are moving average lines, but not the usual moving average lines of Wall Street.Instead of being based on time they are based on volume. That is, heavier volume dayscontribute more to the moving average than do light volume days. A complete discussion of Volume Adjusted moving averages is beyond the scope of this presentation. Iwould suggest anyone interested in the derivation of these lines read my book entitled“Trading Without Fear”. For the purposes of understanding the information on thecharts, notice that the two lines tend to cross at or near important buy and sell points.Because they are volume adjusted they tend to be more sensitive to the heavy volumeof tops and bottoms, and give earlier signals than do the usual time-based moving averages. The hand calculation of these lines is an immense job, but with today’s computersArmsInsider.com
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and sophisticated programs, we can easily use them without worrying too much abouthow they are derived.Across the top of the chart are seen another pair of lines. They too involve a difficult setof calculations, but are nothing to a computer. They represent two values for the Easeof Movement. Ease of Movement is a method of valuing each of the Equivolume boxesnumerically, taking into consideration the size and shape of each box and the directionand extent of the daily price change. It is an attempt to ascertain whether it is easier forthe stock to move up or down at any given time. As with the Volume Adjusted movingaverages, we look at the crossover of the two lines as a clue to future price direction. Acomplete discussion of Ease of Movement is available in my book entitled “VolumeCycles in the Stock Market”. These, and my book entitled “The Arms Index”, are available for purchase at our website bookstore, or through most book dealers.Obviously, these charts represent a sophisticated set of computer programs. In the earlydays I drew charts by hand, and did the complex calculations of Ease of Movement andVolume Adjusted moving averages with a hand calculator. Today there is no need for that.All the charts in this book were produced using the Metastock program marketed by EquisInternational. (http://www.equis.com/metastock/windows95nt/) Tell them you areinterested as a result of talking to Dick Arms and you get a discount. As an ArmsInsidersubscriber, you may want to have this program in order to follow up on suggestions afterthe original recommendation has been made.
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TURNING POINTSTops and bottoms are not for buying or selling, they are for covering long or short positions. A possible top is an unconfirmed move, and trying to short a stock on that basisis too risky. But it is a time to take a profit. Similarly, something that looks like a bottom is a good time to get out of a short position, but the risks are far too high to use it asa buy point. We will look first at Equivolume signals that suggest tops and bottomsbecause they are the most obvious boxes on an Equivolume chart, usually. Later wewill look at the signals that are going to be our buying or shorting points.When a stock gets to a top, it usually tells us so. Volume becomes heavy, and the pricerefuses to move. That produces an Equivolume box, or a series of Equivolume boxes,that are very wide for their height. You will often see them referred to as “oversquare”boxes.Ease of Movement (-0.1338), Ease of Movement (-0.3632)
76543210-1-2-3-4-5
ALBERTO CULVER (39.00, 39.00, 37.75, 38.50)
44.0
square
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oversquare
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On the chart above we see a number of instances in which the trading range becamevery tight while the volume became heavy. That produced the square and oversquareboxes. The reason for this happening is simple. After an advance, there are still buyerstrying to push the price higher. But they are encountering well-entrenched sellers whoare willing to give them all the stock they want at a given price. As the buyers pushupward and the sellers resist, heavy volume is created, but the price acts as though ithas encountered a brick wall. It is usually a clear sign of a top, and a warning thatArmsInsider.com
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prices are likely to head lower. In trading stocks we will usually believe such a sign,and be willing to take the profit. Obviously, there are exceptions, but it holds true oftenenough for us to heed the warning.Often a stock will make a double or a triple top before heading lower. For a longerterm investor that is a signal to get out, but as traders, we are not likely to wait thatlong. Typically a triple top shows up as a big square entry on the first top, and thendiminishing volume on the subsequent tests of that top. A trader is well advised to getout on the first big square, and take the profit. If it goes higher later, instead of forminga double or triple top, who cares.Ease of Movement (-0.2311), Ease of Movement (-0.2714)
0.40.30.20.10.0-0.1-0.2-0.3-0.4-0.5-0.6-0.7
double top
ALLSTATE (34.88, 35.13, 33.88, 34.75)
45.545.044.544.043.543.042.542.041.541.040.540.039.539.038.538.037.537.036.536.0
breakout buy signal
35.535.034.534.033.533.0
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On the chart above, we might have been buyers when the stock broke out above resistance. Just a few days later, at much higher prices, we started to see signs of resistance.That was the time to take the profit. Later it did go back up to that level, and formed awide double top. That then led to a very big decline. But, as traders, we would nothave waited around for all of that. The stock told us very early that it was running intoresistance and should be sold.Unfortunately they do not always act exactly as we expect. Sometimes the toppingaction will be far less obvious.
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Ease of Movement (0.4951), Ease of Movement (-1.841)
4.03.53.02.52.01.51.00.50.0-0.5-1.0-1.5-2.0
AMERADA HESS (67.13, 67.38, 66.25, 66.94)
77767574
not an obvious top
7372717069
breakout levels
6867666564
downside volume
63626160595857
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The breakout was obvious in the stock above, and the subsequent move was very gratifying. But, when it reached the top it did not tell us so. The range did contract, but thevolume was not excessive. Only a couple of days later did it become apparent thatthere was trouble. The clue was the heavy downside volume with a wide tradingrange. The ascending trend was broken, and it looked as though the stock was headedlower. On tops that are not typical, we need to watch for other clues.Lows tend to be different than highs. They are more emotional. Fearful selling oftenresults in climactic action, in which volume becomes very heavy and the trading range,unlike a top, is wide. Therefore we are more likely to see very large Equivolume boxeson bottoms, but they are less likely to be square or oversquare. The typical bottom consists of a big box that washes out the sellers, followed by an immediate rally, and then alighter volume pullback that tests the old support.
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Ease of Movement (0.00938), Ease of Movement (0.02319)
0.040.030.020.01-0.00-0.01-0.02-0.03-0.04-0.05-0.0629.529.028.528.027.527.026.526.025.525.024.524.023.523.022.522.021.521.020.520.019.519.018.518.017.517.016.