When volume is high, those traders unlucky enough to be losing money in their positions feel the sharp sting of their losses. In order to alleviate the pain, these traders quickly close their positions (at a loss). As losers exit the market, a trend based on high volume is likely to be short lived. But a trend based on moderate volume can last an extremely long time since small losses can accumulate over time into what may become very large losses. The longest trends are probably driven by markets either going nowhere, changing moderately or even moving both up and down day after day, forming only a gradual trend, which is apparent when viewed in retrospect.

TUTORIAL: Market Strength

But there's still more to the volume story that pertains to market psychology. It would take many articles to cover the theme of market psychology in its entirety - there are many more trading indicators that gauge the market's psychological state. This article owes thanks to Dr. Alexander Elder for his work, which renders many of the following concepts and indicators in a clear, concise and understandable way for traders everywhere. For much greater detail on all of the topics mentioned below, you can refer to Dr. Elder's trading book companions: "Trading for a Living: Psychology, Trading Tactics, Money Management" and "Come into My Trading Room: A Complete Guide to Trading".

On-Balance Volume (OBV)
Devised by Joseph Granville, on-balance volume is a running total, which rises or falls every trading day, based on whether prices close higher or lower than on the previous day. OBV is a leading indicator, so it typically rises or falls before that of the actual prices. A new OBV high indicates the power of bulls, the weakness of bears and the likely resultant rise of prices. A new OBV low indicates an opposite pattern: the power of bears, weakness of bulls and a possible decrease in value. When OBV shows a signal differing from that of actual prices, it indicates that volume (emotion of the market) is not consistent with consensus of value (actual prices) - a shift in price, which would alleviate this imbalance, is imminent. (For additional reading on volume, see Gauging Support And Resistance With Price By Volume.)

Accumulation/Distribution (A/D)
Accumulation/distribution is also a leading indicator pertaining to volume, but it takes opening and closing prices into account. A positive A/D indicates that prices were higher when they closed than when they opened; a negative A/D indicates the opposite. But the bull or bear winners are only credited with a fraction of each day's volume, depending on the day's range and the distance from opening to closing price. Obviously, a wide range between open and close produces a stronger signal A/D, but the pattern of A/D highs and lows is most important. If a market opens higher and closes lower, thereby causing A/D to turn down, an upward-trending market may be weaker than it initially appears.

The significance of accumulation/distribution lies in its insight into the activities of the distinct groups of professional and amateur traders. Amateurs as a group are more likely to influence the opening price of the market since these amateurs base their first trades on the financial news they have read overnight as well as on the corporate news that was issued by their favorite companies after market close. But as the trading day wears on, the professionals determine the day's ultimate results. If the professionals disagree with the amateurs' bullishness at the open, the professionals will drive prices lower for the close. When the pros are more bullish than amateurs, the pros will drive prices higher all day and into the close. As indicators for future trends, the activities of professionals are generally more important than that of the amateurs. (For more, see Trend-Spotting With The Accumulation/Distribution Line.)

Open Interest
Shifting from our discussion of volume, we find open interest as the next major indicator of crowd psychology. Open interest applies to the futures market and refers to a reading of future contracts or options expiring at a certain time in the future. Open interest adds the total long and short contracts in the market on a given day, and the absolute value of open interest corresponds to a cumulative long or short position. Open interest only rises or falls when a new contract is created or destroyed - one long and one short seller must enter the market to increase the open interest, and one long and one short seller must close their positions for open interest to fall.

Open interest is only of interest (pun intended) when it deviates from its norm. An absolute value is of no interest (bad pun again intended). Open interest reflects the psychology of the market by way of the market's inherent conflict between bulls and bears. To move the open interest indicator up or down, both bulls and bears must be equally confident that their long or short position is correct (or incorrect). A rising open interest demonstrates that bulls are confident enough to enter into contracts with bears, who are equally confident in their bearishness to enter into the position. One group will inevitably lose, but as long as potential losers (either bulls or bears) enter contracts, the rise or fall in open interest will continue. But there is more to the open interest picture than immediately meets the eye. (For more, see Discovering Open Interest.)

Reading Open Interest Signals
A rising open interest points to an increase in the supply of potential losers, propelling the trend forward. Open interest that increases during an uptrend reveals that a certain number of bears believe the market is too high; but, if the uptrend increases, their short positions will be squeezed, and their subsequent buying will propel the market even higher; however, open interest that remains relatively constant during a market uptrend indicates that the supply of losers has stopped growing as the only potential candidates to enter into a contract are previous buyers who are looking to make a profit from their position. In this case, the uptrend is likely nearing its end.

During a downtrend, shorts are selling aggressively while the only participants that are buying are bottom pickers. But even value investors exit their positions when prices fall too far, so prices will go even lower. If open interest rises in a declining market, the downtrend is likely to continue. If open interest remains flat in a downtrend, there are few remaining bottom pickers, and the only remaining candidates for the contract are additional bears that shorted earlier and now want to cover and leave the market. Bears that exit with a profit cause a flat open interest in a downtrend, meaning that the best gains from the downtrend have probably already been had.

Falling Open Interest
Finally, a falling open interest shows that losers are exiting positions while winners are taking profits. It also shows there are no additional losers to take the place of those who have given up. The falling open interest is a clear signal that winners are taking their profits and running for the border while losers are giving up hope. A loss of a contract (and a declining open interest) points to the likely end of a trend.

The Bottom Line
There are times when reading the market trends and market psychology using specific metrics seems as effective as Roman soothsayers reading entrails. However, if you carefully pick the indicators, understand their limitations and use them in tandem, you will be much better positioned to spot the market's mood and adjust for what that mood means for your positions. (For more, check out Gauging Major Turns With Psychology.)

Related Articles
  1. Chart Advisor

    ChartAdvisor for November 27 2015

    Weekly technical summary of the major U.S. indexes.
  2. Chart Advisor

    Pay Attention To These Stock Patterns Playing Out

    The stocks are all moving different types of patterns. A breakout could signal a major price move in the trending direction, or it could reverse the trend.
  3. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  4. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  5. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  6. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  7. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  8. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  9. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  10. Chart Advisor

    Watch These Stocks for Breakouts

    These four stocks are moving within price patterns of various size, shape and duration, and are worth watching for a breakout
  1. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  2. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  3. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  4. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  6. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Flier

    The slang term for a decision to invest in highly speculative investments.
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center