Volume Divergence for Effective Prediction

The importance of volume divergence in effective trading, and the information it provides as far as what determines stochastic indicators, cannot be overlooked. Divergence theory is rooted in the idea that within a vector field, a three-dimensional one at least, the divergence is the amount to which the flow of the field acts like a source, or sink, at various points. Basically, it quantifies outward flow, measuring how much as exiting a region versus how much is coming back into the same space.

The stochastic oscillator utilizes this idea, but further expands on it. With the stochastic system of analysis, traders are able to look at the current price of a security and analyze its range over time. Just as divergence measures the sink within a particular field, stochastic oscillation measures the divergence between the closing price and its range across a particular period, thereby accurately assessing the high and low points of a stock. The combination of the two theorems, make for a winning combination for any trader.

A non-confirmation by volume occurs when volume is falling while a stock's price is going up. Volume divergence over 1 or 2 days is not what we are concerned with. We are looking at the volume trend over 5 or more days. The longer the volume trend shows volume dropping while price goes up, the more significant the volume divergence signal.

In a strong up-trend, we would expect volume to be rising with price. This indicates that an ever greater number of traders are participating in the upward move and this increased demand for the stock will continue to push it higher. If you are long a stock, you would like to see volume decline on sell-offs because this would serve as a non-confirmation of lower prices, or that traders are willing to hold shares even on a retracement, and not sell them. The combination of volume divergence and Fibonacci retracements are another winning combination. There is a greater probability of a Fibonacci reversal off a 38.2%, 50%, or 61.8% retracement level when there is a non-confirmation of lower prices.

The opposite is also true. If you a short a stock, then in a down-trend, you want to see the volume trend rising as price is making new lows, which serves as a confirmation of these new lows. When the stock swings higher, you want to see non-confirmation of higher prices, or that traders are selling shares as soon as they can on a bounce.