ACTA WASAENSIA 95

The price-volume behavior of an equity:

theoretical approach

Martti Luoma, Jussi Nikkinen, and Petri Sahlström

Dedicated to Ilkka Virtanen on the occasion of his 60th birthday

Abstract

Luoma, Martti, Jussi Nikkinen, and Petri Sahlström (2004). The price-volume behavior of
an equity: theoretical approach. In Contributions to Management Science, Mathematics
and Modelling. Essays in Honour of Professor Ilkka Virtanen. Acta Wasaensia No. 122,
95–105. Eds Matti Laaksonen and Seppo Pynnönen.

In spite of the fact that the technical analysis has been used for decades to analyse stocks
and other commodities, the theoretical development in the area is very limited. The
purpose of this article is to present the theoretical background for the price-volume
behavior of a stock which is a well-known tool in technical analysis. The theoretical
background stems from the supply and demand curves of the economics literature that are
used to investigate how a particular market reacts to changes in supply or demand. By
applying theory of supply and demand we build a theoretical background for important
rules of technical analysis. Until now the justification of the rules has been purely
empirical. Moreover, the theoretical background introduced helps to understand the
dynamics of the equity market where the flow of information has an essential role. Since
our analysis has only a few first steps for depicting the determination of equity prices by
behavior of sellers and buyers, we hope that the article will encourage work in this
important research area.

Martti Luoma, Department of Mathematics and Statistics, University of Vaasa, P.O. Box
700, FIN–65101.
Jussi Nikkinen and Petri Sahlström, Department of Accounting and Finance, University of
Vaasa, P.O.Box 700, FIN-65101.

Key words: technical analysis, supply and demand curves, volume.

1. Introduction

In spite of the fact that the technical analysis has been used for decades to analyse stocks
and other commodities, the theoretical development in the area is very limited. Tools and
methods in technical analysis are developed in practise and most of them are “ad hoc” in
nature, lacking any theoretical justification. This is a serious drawback, since without
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theoretical background we cannot know, for example, how a tool used to analyse stocks
works as a stock market environment changes.

From the academic point of view the lack of theoretical background has been one of the
key reasons why the academic research in the area is rather limited. Moreover, the
research conducted is only able to answer the question whether some tool works in a
specific market environment used in empirical analysis. Consequently, the results, without
any theoretical justification, are basically valueless for the users of the technical analysis
since the market conditions change all the time.

The situation, however, is changing in the academic research as the so-called behavior
finance literature grows. In this area, the purpose is to investigate how and why different
types of market participants are doing their trades in the market-place. This is important
for the users of technical analysis since the methods used are based on market information,
such as trading volumes, which is caused by the traders in the market place. I.e. trading
behavior is behind the information used in technical analysis.

One example of this interesting research area is a study by Gervais, Kaniel, and
Mingelgrin (2001) investigating whether the trading volume of a common stock can be
used to predict stock returns. Based on the visibility hypothesis by Miller (1977) they
argue that in future the stocks with higher (lower) than normal trading volume will have
better (worse) returns than other stocks. The main point in the visibility hypothesis is not
the trading volume itself, but instead the visibility observed in the trading volume. In other
words, Miller (1977) states ‘In theory, high volume does not indicate that the stock will
rise and merely observing heavy trading volume should not cause anyone to buy.
However, if the volume does attract attention and cause more people to look at a stock,
some are likely to persuade themselves that the stock should be bought.’ This indicates
that as the visibility increases, especially for small firms, their stock prices increase. The
empirical results by Gervais, Kaniel, Mingelgrin (2001) support the visibility theory.

The purpose of this article is to present the theoretical background for the price-volume
behavior of a stock. This price-volume behavior is a well-known tool in technical analysis.
 ACTA WASAENSIA 97

The theoretical background stems from the supply and demand curves of the economics
literature which are used to investigate how a particular market reacts to changes in supply
or demand.

2. Empirical criteria for the price-volume behavior of a stock

A common notion in handbooks of technical analysis (e.g. Elder 1993) is that increasing
trading volume strengthens trend, i.e. increases the probability that the ongoing trend will
continue. Conversely, falling trading volume signals that the current trend is going to
reverse, i.e. the probability that a trend reversal is going to happen increases. More
precisely we analyze four empirical price-volume rules generally used in the practice (see
e.g. Young 2000). The rules are as follows:

1. Increasing volume on increasing price indicates possible price increase.

2. Increasing volume on decreasing price indicates possible price decline.
3. Decreasing volume on increasing price indicates possible price reversal or sideways
movement.
4. Decreasing volume on decreasing price indicates possible price reversal or sideways
movement.

These rules are frequently used in technical analysis. The rules are clear and consistent but
they are difficult to use in practise. Much experience is needed to use them. This is partly
because volume has rather a big random component. It can be seen in any graphic
presentation, for example in Figure 1. We have drawn a grid and 20 days’ moving average
of volume for better visualization. Healthy uplegs and healthy downlegs should have
increasing respective declining volume. According to Figure 1 a volume of Tietoenator
from Helsinki Stock Exchange trend has been increasing until mid-November and then it
has begun to decrease. After mid-November we have to follow prices very carefully.
Uplegs should have increasing or big volume and downlegs should have decreasing or
small volume. Not before last downleg in January can we see unhealthy development. It
follows a downward breakout with increasing volume.
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Tietoenator
33 33

32 32

31 31

30 30

29 29

28 28

27 27

26 26

25 25

24 24

23 23

22 22

21 21

20 20

19 19

18 18

Volume
50000 50000

x10 x10
7 24 1 8 15 22 29 5 12 19 26 3 10 17 27 7 14 21
October November December 2002

Figure 1. Tietoenator with increasing trend.

HEXportfolio
2750 2750

2700 2700

2650 2650

2600 2600

2550 2550

2500 2500

2450 2450

2400 2400

2350 2350

2300 2300

2250 2250

2200 2200

2150 2150

2100 2100

Volume

50000 50000

x1000 x1000
18 25 2 9 16 23 7 13 20 27 3 10 17 24 3 10 17 24 31 7 14 22 28 5 12 19 26 2 9
December 2003 February March April May June

Figure 2. Hex portfolio index with a downtrend.

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In Figure 2, the HEX portfolio index of Helsinki Stock Exchange has a volume trend that
began to decrease from the beginning of February, signaling that the probability of a price
trend reversal has grown. Trend breakout happens with increasing volume fairly soon after
a volume trend has began to increase.

These two examples are rather easy to interpret using four rules presented above and other
knowledge about technical analysis. Usually a graph is much more difficult to interpret. In
this article, the objective is to find a theoretical background for these four rules.

3. Supply and demand curves

In economics financial assets are considered as commodities. Supply and demand of an

ordinary commodity is presented in Figure 3 (see any text-book in economic analysis, for
example Varian 1999). The curve “Demand” represents the dependence of the demand on
the price, ceteris paribus and the curve “Supply” presents the dependence of the supply on
the price, ceteris paribus. Consequently, the interpretation of supply and demand curves is
based on the idea that one curve moves and the other remains same, i.e. the equilibrium
point moves to the right or to the left.

Demand Supply
Price

Demand, Supply

Figure 3. Typical demand-supply curves with an equilibrium point.

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On asset markets, information arrives both during the trading day and overnight. As a
consequence of this information arrival, the demand curve does not remain unchanged but
changes. If the information is not very exceptional and the liquidity of the financial asset is
high enough, the demand and the supply will be in equilibrium at the end of the trading
day. Moreover, the daily changes will be approximately equal in size. If the supply is
greater than the demand, the prices will fall from Pa to Pb as shown in Figure 4. If, on the
other hand, the demand is greater than the supply, the prices rise from Pb to Pa. The
problem is the fact that on financial markets supply and demand are not known in
advance. There are always as many sales as purchases and consequently, the exchange
trading volume does not help in clarifying, the supply-demand situation. A questionnaire
survey could in principle be used to analyze the relation of demand and supply. In practice
it is not a useful approach, however, and therefore, practical and theoretical considerations
about price-volume behavior are needed.

Demand Supply
Price

Pa
Pa

Pb

Demand, Supply

Figure 4. If supply is greater than demand the price falls (from Pa to Pb). If demand is
greater than supply the price rises (from Pb to Pa).

4. Uptrend

Applying demand curves and supply curves to analyze the behavior of stock prices is
problematic since along with the new information the curves may change. However, the
 ACTA WASAENSIA 101

trend represents a certain form of stability. For this reason, the trend and its evolvement
can be perhaps described and can be understood by analyzing the curves. It is assumed
that no unexpected news regarding either the company or the macroeconomic environment
is released. The stock becomes popular and new buyers appear in a steady flow. Demand
leads to further demand and the trend continues as long as new buyers appear. Figure 5
illustrates the situation of the upward trend. As can be seen in the picture, the trading
volume also increases. The trend in question is often called “a healthy trend” in technical
analysis because the trend will with high probability continue. This corresponds to the first
empirical criterion above. It is assumed that the supply curve remains the same. This will
be a reasonable assumption provided that the time span is not too long, since in the case of
a rising trend the buyers' behavior determines the price level. The demand curve changes
quite regularly way while the supply curve stays the same. For the sake of simplicity the
random component of the price as well as the cyclical component are ignored here and
also in the future examinations. Figure 1 is a representative example of an empirical
uptrend. To remove noise and cyclical variation in volume figures, the 20-day moving
average is presented. The figure shows that the moving average increases from the turn of
September-October, i.e. nearly from the beginning of the trend, to the end of November.
This part represents the healthy part of the trend and indicates that the trend will continue.

Supply
2,5
Demand 3

2
Demand 2
Demand 1
Price

1,5

0,5

0
0,2 0,3 0,4 0,5 0,6 0,7 0,8
Demand, Supply

Figure 5. Healthy uptrend.

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5. Downtrend

In the case of the downward trend the sellers are the ones who determine the trade price.
When the market is decreasing, new sellers appear on the market in a steady flow. While
nothing has essentially changed in companies, it is the attitude of the owners regarding the
share which has changed. Figure 6 represents the case of a downward trend. The demand
curve stays the same but the supply curve will change when the sellers' behavior
determines the behavior of the financial asset prices. The figure again shows a stage of the
healthy trend, the volume increases, in other words more sellers appear on the market.
This corresponds to the second empirical criterion. Figure 2 shows the development of the
HEX portfolio index as an example of a downward trend. It can be seen that the trend
begins around the middle of January. At the same time, the trading volume increases and
increases throughout January. This indicates that the trend is likely to continue. Figure 2
shows that the trend has still indeed lasted all through February.

Demand

Supply 1

Supply 2
Price

Supply 3

Demand, Supply

Figure 6. Healthy downtrend.

6. Ending of the uptrend

When a rising trend dominates, the new buyers flow evenly onto the market. It raises the
price of a financial asset which in Figure 7 is seen as the transition of the demand curve.
 ACTA WASAENSIA 103

At some stage of the upward trend, the share owners become aware of the rising trend of
the stock. The share has become ’hot’ or popular and the current shareholders become
greedy and are not willing to sell at the price indicated by the current supply curve. This
leads to the upward transition of the supply curve as presented in Figure 7. Soon the
emergence of new buyers also will begin to decrease, which in the figure implies the
smaller transition of the demand curve. From the figure it can be seen that the trading
volume becomes smaller, which is in accordance with the third empirical criterion. When
the investors start to extensively cash their stock positions, the stock price will begin to
decrease. In our example (Figure 1) trading with Tietoenator becomes smaller from the
middle of November to the middle of January, in which phase the trend line breaks.

Supply 2

Supply 1
Demand 3 C

Demand 2

Demand 1

Figure 7. Ending of a uptrend.

7. Ending of the downtrend

The share will get a bad reputation after the downtrend has taken long enough and nobody
will want to buy it. This leads to a decrease in the demand curve in Figure 8. Both price
and volume decrease which is in accordance with the fourth empirical criterion. At some
stage “wise money” considers the share underpriced and begins to buy it. At least the first
stage of this phase is easily hidden by the pessimism on the market.
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D emand 1

D emand 2
Supply 1
A

B Supply 2

Supply 3

Figure 8. Ending of a downtrend.

8. Conclusions

This article has contributed the literature by presenting justification for four price-volume
rules of technical analysis by using demand and supply curves from economics literature.
In this way we have built a theoretical background for important rules of technical
analysis. Until now the justification of the rules has been purely empirical. Moreover, the
theoretical background presented helps to understand the dynamics of the equity market
where the flow of information has an essential role. Since our analysis has only a few first
steps for depicting the determination of equity prices by behavior of sellers and buyers, we
hope that the article will encourage work in this important research area.
 ACTA WASAENSIA 105

References

Gervais, S., R. Kaniel & D.H. Mingelgrin (2001). The high-volume return premium.
Journal of Finance LVI, 877–919.

Elder, Alexander (1993). Trading for living. Kogan Page.

Miller, E. M. (1977). Risk, uncertainty, and divergence of opinion. Journal of Finance 32,
1151–1168.

Varian, Hal R. (1999). Intermediate microeconomics. A modern approach, fifth edition.

New York. London: W.W. Norton & Company.

Young, William (2000). Parallel trading. Active Trader (July), 22–25.