You’ve seen earlier in this article that each tick on a chart reflects a transaction between two persons: a buyer and a seller (in case of automatic trading one or both of them may have been a computer program). The buyer believes that the stock is undervalued and will go up. Had he thought otherwise, he would’ve waited to buy it lower. The seller believes the stock is overvalued and about to drop – otherwise he would’ve waited to sell it higher. Each of them thinks he is right, but only one will make money, while the other will lose.
Rising volume reflects a greater degree of conviction among both winners and losers. As long as losers believe they’re right, the trend that’s impaling them can continue. Joe Granville, the late great market analyst who did some of the pioneering work on volume, used to say: “Volume is the steam that makes the choo-choo go.”
Most people plot volume as vertical bars underneath price bars or candles. I prefer to track volume using an indicator that I developed: Force Index. Here is its formula for the daily charts:
FORCE INDEX = (Close of today minus close of yesterday) times volume of today.
Force Index multiplies today’s price change by the volume it took to accomplish that change. It can be positive or negative, depending on whether today’s close was higher or lower than yesterday’s. The greater price change and the greater the volume, the greater the Force Index.
We need to smooth Force Index with a moving average. A 2-day EMA of Force Index helps catch short-term swings, while a 13-day EMA of Force Index helps identify intermediate-term tops and bottoms.
A 2-day EMA of Force Index helps identify trade entry points. Once you’ve made a decision to buy during an uptrend, a decline of the 2-day EMA of Force Index below zero identifies a bargain area. Once you decide to sell short during a downtrend, a rise of the 2-day EMA of Force Index above zero marks a short-term overvalued condition, a shorting opportunity. On the chart above we use the slope of the slow moving average to identify the trend. Green horizontal bars mark the areas where 26-bar EMA rises and pink horizontal bars where it declines.
1.) Find the “Indicators” area below the chart.
2.) Click on oTo add the 2-day Force Index to your chart,
ne of the Indicator dropdowns and select “Force Index”
3.) Change the “Parameter” setting from “13” to “2”
4.) Click the “Update” button
It pays to look for divergences between the Force Index peaks and bottoms and prices. A bullish divergence is marked on the chart above with a diagonal green arrow. Divergences between the rising bottoms of the Force Index and price bottoms show us when bears are losing power. They alert us to buying opportunities.
Watch out for downspikes of Force index, such as the one on the left side of the green arrow. Whenever the 2-day EMA of Force Index spikes down five times or more its usual depth and then recoils from that low, expect prices to rally in the coming days. Keep in mind that while downspikes often lead to upside reversals, upspikes don’t provide shorting signals.
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A 13-day EMA of Force Index helps track longer-term balance of power between bulls and bears. When it crosses above its centerline, it shows that bulls are in control and suggests trading from the long side. When it turns negative, it shows that bears are in control and suggests trading from the short side.
To add the 13-day Force Index to your chart,
1.) Find the “Indicators” area below the chart.
2.) Click on one of the Indicator dropdowns and select “Force Index”
3.) Click the “Update” button
Divergences between a 13-day EMA of Force Index and prices identify important turning points, and we see two of them in Figure 18. The top B is higher than the top A, but Force Index is lower, showing that bulls have become weaker – it is a bearish divergence.
Notice “breaking the back of the bull” between the two tops of Force Index, a necessary condition of a true divergence.
There is a bullish divergence between the bottoms X and Y. Prices are slightly lower at the second bottom, but the bottom of the Force Index is shallower; a rally between those bottoms “broke the back of the bear.”
Notice also a false upside breakout in area B and a false downside breakout in area Y. When independent technical signals, such as divergences and false breakouts occur together, they reinforce each other’s messages.
Experienced traders wait until a clear pattern reaches out to them from the screen and “grabs them by the face.” Don’t settle for questionable or foggy patterns. You get paid for trading well, not for trading often. Keep scanning your stocks and trade only when the picture you see at the right edge is near perfect.
Force Index spikes work quite differently on the charts of the 13-bar Force Index. Here they provide tremendously useful signals – but only on the weekly charts where they help catch trend reversals. This idea came from Kerry Lovvorn, my partner in SpikeTrade.com who added a 3-ATR channel to the Force Index. The signals we’re about to discuss don’t mark every reversal – but the ones they catch are worth trading.
When the 13-week Force Index escapes either above or below its 3-ATR Keltner channel, it marks a stampede by either bulls or bears. It takes an uncommonly strong burst of optimism to raise the 13-week Force Index above its 3-ATR channel. It takes an unusually powerful wave of fear to push this indicator below its 3-ATR channel. The crowd can’t sustain those moves for long. When they start choking up and the 13-week Force Index returns into its channel, it shows that prices are ready to reverse and retrace at least a part of their previous move.
Arrows 1, 4, and 6 on the weekly chart above show where bears ran out of steam and gave buy signals; each was good for several weeks. Arrows 2, 3, and 5 show where bulls began to choke up and gave signals to sell and sell short. Only one signal out of six (arrow 2) didn’t work out. There are no perfect signals in market analysis, which is why we must use protective stops. How to set them is described later in this book.
To add Keltner Channels to your Force Index, follow these steps:
1.) Scroll down to the “Indicators” area below the chart and find the line with your Force Index settings.
2.) Find the “Overlay” dropdown located on the far right of that same line. (See the screenshot below for help.)
3.) Select “Keltner Channels” from that dropdown
4.) Change the corresponding “Parameters” box to “26,3,26”
5.) Click the “Update” button.
