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Wednesday, December 26, 2007

Accumulation / Distribution: A Powerful "Early Warning" Tool - Part I

So from our last blog, we understand the rules regarding volume and open interest when considering a market. If the price moves up, and the volume moves up, we have a good trend. Right?

But if we recall what we have learned in previous months, it is vital to understand the theory behind why we use a particular indicator. What is volume really telling us? Why is it so important to consider volume?

Investopedia has an excellent definition of volume, that assists us to understand it's worth. It says:

Volume is an important indicator in technical analysis as it is used to measure the worth of a market move. If the markets have made strong price move either up or down the perceived strength of that move depends on the volume for that period. The higher the volume during that price move the more significant the move. - Investopedia

Therefore, it gives us an indication as to the sentiment of the market on any given move. When dealing with any market, it is the market itself that is determining the worth and price of any item for sale, correct? Supply and demand. So if we have a volume of 3, then the overall market has only traded 3 shares of that particular item. The market is not demanding much of such an item. But what if we see 3,000,000 as a volume? This means that on that day, 3,000,000 shares have traded hands. This indicates the market deems this item to be of higher interest. More trading must be taking place, for that number of shares to change hands. This is why we look for changes in volume patterns, in relation to a chart over time. The market can tell us what it's thinking about recent moves.

Many tools have been developed, based off of volume to take advantage of this thought. One of them, is called "Accumulation / Distribution". This tool adds or subtracts each days volume, from another subset. That subset is where the close is at, in relation to the days high, and the days low. The resulting number is plotted on a line, beginning from zero. The divergent patterns that arise with this indicator, are of great worth.

Ok, let's return to our earlier thesis of understanding the theory behind a tool. What is Accumulation / Distribution as a tool trying to measure, and what can this tell us? Why is it of great worth?

It is believed that a market comes under a period of accumulation. And what moves a market? Supply and demand, correct? When buyers are heavily demand a particular stock, it's price will rise. The market is said to be in a 'buying accumulation', and the stock price will then start to rise. Others believe that market guru's who have either a) inside information, or b) intensely skilled at picking good stocks, will quietly start this 'accumulation'. Whether or not this is true, we do have to admit that based off the simple mechanics of supply and demand, when a market comes under intense buying pressure, the market will rise. Conversely, when a market comes under more and more selling pressure, a market will fall. Accumulation / Distribution is designed to try to measure and tell us when such buying accumulation, or selling distribution is taking place.

How does one use the Accumulation / Distribution tool? How do you read it to try to gain such signals?

Well, the first rule is that as an volume indicator it is not to be considered an 'oscillator', with precisely timed buy signals for specific days, such as say, the Williams %R tool. Instead, you must view it as an 'early warning' tool. Accumulation / Distribution will tell you as an investor or trader what the bias to an individual market may be, but not when the price will reflect that bias. This is why I call it an "Early Warning System". Much like a Tornado Siren, it will warn you as to possibilities, but not tell you exactly when a 'storm' will take place, or even if it will take place at all. It merely alerts you to the bias.

How? What are the mechanics of reading this tool? I will discuss this in tomorrow's Part II blog entry . . .

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