Monday, April 4, 2011

Dormeier, Investing with Volume Analysis

In addition to his “real” job managing money, Buff Pelz Dormeier develops technical indicators. He shares some of the fruits of his—and his noteworthy predecessors’—labor in Investing with Volume Analysis: Identify, Follow, and Profit from Trends (FT Press, 2011).

When I started reading this book I suspected that it would be like so many others: long on generalities and short on actionable ideas. The first hundred pages or so do indeed deal with general relationships between price and volume, and some of the material is familiar. But even the familiar material is often presented in an unusual way. Here’s one example.

Newton’s second law of motion, reinterpreted to apply to financial markets, analyzes “how much volume (force) is required to move a security (the object) a given distance (price change) at a given speed (acceleration/momentum). … Richard Wyckoff referred to this principle as the law of effort versus result, which asserts that the effort must be in proportion to the results.” (p. 47) As a corollary of this law, “if more volume (force) is required to produce less price change (acceleration), then the stock is becoming overly bought or sold.” (p. 85)

In apparent contradiction to Wyckoff’s law of effort is the rule of trend volume, according to which “more volume substantiates a stronger trend.” (p. 85) Can these two principles be reconciled? Dormeier suggests that they can, once we bring the notions of strong hands and weak hands into the equation. His discussion is too detailed to summarize here, but it is premised on how strong hands and weak hands play the game. As he writes, “Strong hands buy out of an expectation of capital appreciation. Weak hands buy out of greed and the fear of missing out on an opportunity. Weak hands sell from the fear of losing capital. Strong hands sell to reinvest in better opportunities (which does not have to be other equities).” (p. 87)

Dormeier really hits his stride when he turns “general volume principles into indicators with numerical values.” (p. 113) These indicators have a dual mandate—to lead price and to confirm price. But they don’t all work the same way; they are “tools, each of which is designed to explain a distinct piece of the volume puzzle.” (p. 117)

The author differentiates seven types of volume indicators; put otherwise, “volume indicators provide information in seven different ways.” The types (or ways) are: pure volume, volume accumulation based on interday price change, volume accumulation based on intraday price change, volume-price range indicators, price accumulation based on volume, tick volume, and volume-adjusted price indicators. He devotes brief chapters to each of these types of indicators, acknowledging their creators, describing their construction, and judging their usefulness. Perhaps the most bizarre are the price-volume charts created in the 1950s by Benjamin Crocker; they form “lines that resemble a toddler’s drawings on an Etch-a-Sketch.” (p. 124)

Dormeier’s own contributions lie in the realm of volume-weighted price indicators. Most notably, volume-weighted moving averages, volume-weighted MACD, the trend thrust indicator, and the volume price confirmation indicator. He has also devised a trailing stop that combines the VPCI with Bollinger Bands. And, to resolve the “significant disconnect between the relationship of the price index to the index’s volume totals,” (p. 227) he introduces the reader to cap-weighted volume. He explains how to construct each of these indicators.

The returns for Dormeier’s indicators are impressive. The only problem is that he developed them some time ago and tested most of them on data from the 1990s and the early 2000s. He did not update the backtests for this book, so I have no idea what kinds of results they would have produced over the last five years or even the last year.

Some people argue that volume analysis is really a thing of the past now that we have high-frequency trading adding substantially to volume totals. The author thinks not. “Non-directional trading,” he writes, “does not directly affect volume analysis” (p. 302) and the secular growth in volume will have virtually no impact on short- and intermediate-term volume analysis.

Investing with Volume Analysis is an important work for anyone who wants to incorporate volume indicators into a trading system or systems. Dormeier explains the theory, offers indicators for testing, and even describes some interesting ways to segment market data for purposes of testing. For those who think that volume bars at the bottom of the chart say everything there is to say on the subject, this book will be an eye opener.

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