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The two most important market indicators traders watch and base their trading decisions on are price and volume.

When a stock price rises on heavy volume, it generally suggests strong buying interest. When a stock price falls on high trading volume, it indicates strong selling pressure. Heavy volume in liquid stocks almost always indicate smart money (institutional, market makers etc) buying or selling. Even though retail traders can occasionally make a stock move, as was the case with many of the meme stocks, like Gamestop and AMC, these instances are rare and, even in the meme cases, major hedge funds were heavily involved in the trading. In other words, heavy volume is a tipoff that the smart money is making a move.

When a stock price rises on low trading volume, it suggests weak buying interest and when a stock price falls on low trading volume, it indicates weak selling pressure. This weak buying or selling is usually thought to represent retail buyers.

Price moves on low volume are usually not sustainable and tend to reverse in the direction of the original, high volume, move. The reason this happens is based on a combination of market psychology and market manipulation, usually to the detriment of retail traders. 

How the Low Volume Retest Works

For example, let’s say stock ABC hits a major resistance level at 100 and then starts to sell off on heavy volume and reaches a support level at 80. The selloff could have been triggered by a change in fundamentals, a news headline or a general market move. The reason for the move doesn’t really matter. The only thing that matters to traders is that the smart money has decided to sell the stock and reap their profits, and has also probably decided to short the stock.  But in order to sell stock in the kind of volume that the smart money does, they need to have buyers.

Once the stock price has hit 80 and sellers have been exhausted, the smart money can either start covering some of their short positions and take their quick 20 percent profit (100 to 80) or they can push the price higher and then short it again. So they do a little short covering and start buying a little to create the impression that the stock is starting to reverse and rebound. Coincidentally, a positive news headline might come out or perhaps a rumor about a merger or takeover.

Suddenly, the stock price starts moving higher and retail traders following the stock, thinking that the worst is over start buying in the high 80s. Before you know it the stock is back to 90. However, the move up has been on low volume — a combination of smart money tease buying and retail FOMO. Don’t forget, the smart money has no problem buying tens of thousands of shares to get retail buyers excited about the stock move.

At 90 the smart money decides that it’s time to continue their original plan. As retail buyers continue to pile into the stock as it pushes higher, the smart money gets busy selling the shares they bought back at 80, making another nice profit, and adding to their short positions. As the stock starts to push lower, retail traders either get stopped out or scared out of their long positions, causing the selling pressure, and volume, to increase. Now the stock drops breaks through the 80 support on heavy volume and continues lower.

Here’s the final recap: Smart money sold at 100, bought back at 80 and sold again at 90, making nice profits. Retail traders bought in the high 80’s through 90 and sold at a loss. The only way to avoid this retail trap is to watch the volume behind a move.

Let’s look at a real life example.

Below is a daily chart of CAT. The actual dates or price points are irrelevant to our topic. All you need to focus on the price action and the corresponding volume. The white line going across the chart is the 89 day moving average.

Going from left to right, the first set of arrows indicates a break below the 89 on heavy volume and then continuation. Notice the very tall orange volume bars, which let you know that the smart money is in the game. The next group of arrows shows the buying and higher price movement on low volume (retail), which is followed by another selloff on heavy volume (smart money). The second group of arrows shows another price rise on low, and diminishing, volume.

The chart ends with the stock just below the 89 looking like the selling pressure want to strike again. What will happen on the next bar is anyones guess, but going long right here below the 89 with the air coming out of this latest rally is probably not the best move to make.

How to Take Advantage of the Low Volume Retest

Before you kick your laptop and curse the smart money monsters out to get your money, just realize that there’s a silver lining at the bottom of this market mess. If you can learn to identify these weak, low volume price moves, you can get on the same side of the trade as the smart money and cash in just like they do.

When you see a stock pushing higher on low volume after a big move, instead of succumbing to FOMO and jumping in to buy with the rest of the retail community, just wait. And when it looks like the air is coming out of the pumped up rally, which you can tell by the volume drying up, then go short. The challenge is not to get short too early, because the move higher can keep going longer than you thought, even on low volume. [Same holds true if the stock is pushing lower on heavy volume.]

Bottom Line

The underlying strategy to your trading should be to try and trade with the smart money and not against them. The biggest clue to identify what the smart money is doing is to look at the volume behind the price action.  Price moves on big volume usually indicate smart money buying or selling. Price moves on low volume usually indicate retail buying or selling, often stimulated by smart money trading traps.

[Another way of following the smart money is to follow institutional sized options trades. You can identify those options trades using various screening tools.]

Best of luck in following the smart money!

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