In the stock market, trading volume refers to the number of shares/contracts of a stock that have changed hands over a given period of time.
Volume plays a critical role in technical analysis and is recognized as an indispensable indicator that helps confirm trends and patterns.
If the price of a stock with a high trading volume is surging, it means there is buying pressure, as demand from traders pushes the price higher and higher. One the other hand, if a stock with a high trading volume is tumbling, it means more traders are selling their shares.
Volume also gives us early signals when the price movement is likely to continue or reverse.
Having explained the meaning of volume in the stock market, now let discuss the negative volume index (NVI), which is a popular volume indicator among stock traders.
What is a Negative Volume Index?
The negative volume index (NVI) is an indicator that uses change in trading volume to decide when the “smart money” is active.
Here, smart money refers to traders like hedge funds and asset managers at major investment firms. These types of traders are considered to be experienced and well-informed because their stock trades usually involve large amounts of capital and they have to conduct due diligence while picking their next stock.
NVI indicator was conceptualized in the 1930s by Paul Dysart.
However, the version of the NVI indicator that is used today was developed in 1976 by Norman Fosback, the author of the popular book Stock Market Logic.
Breaking down the NVI indicator
NVI indicator assumes that the smart money is most active on days when market is calm and trading volume drops. It also assumes that smart money is least active when the market is turbulent and trading volume is heavy.
The indicator goes down when price goes down on low volume and goes up when price goes up on low volume. It remains unchanged when volume is high, assuming that is when the smart money is active.
NVI indicator is closely related to the positive volume index (PVI) indicator, which aims to identify price moves when the smart money is active.
Hedge funds and asset managers don’t always get it right, but, on average, their stock picks historically yield huge returns after adjusting for known risk factors.
With this in mind, day traders and other smaller investors like to follow the smart money by looking at the stocks that hedge funds and other institutional investors are collectively bullish on.
In this case, traders and chartists compare trading volume with the previous day to see if there is any drop. If there is a drop, the NVI indicator is adjusted.
Basically, the main idea behind the NVI is to keep tabs on hedge funds and other professional traders in order to know the market trend.
If the trading volume drops, but the trend continues, this means that the smart money still believes the market has some potential, and the current trend is likely to continue.
The NVI assumes that the surge in trading volume is as a result of the not-so-smart traders who trade without any prior research. Therefore, when the trading volume is low, the NVI allows traders to understand when the current trend is strong and whether it will continue in an upward trend.
NVI Calculation
Here is a simple guide on how to calculate the negative value index.
NVI= NVIprevious + ( (CPtoday −CPyesterday) / CPyesterday )∗NVIprevious
Where,
- NVI = Negative volume index
- NVIprevious = Negative volume index of the previous day
- CPtoday = Closing price today
- CPyesterday = Closing price yesterday
You can use the NVI formula if the trading volume decreases during a specific period. You can use today’s price calculation as the previous NVI if you don’t have the previous NVI calculation.
If today’s trading volume is equal or higher than the yesterday’s trading volume, the NVI remains the same.
How to use the NVI indicator
Volume analysis is one of the important metrics that help investors understand the market trend from a broader perspective.
The negative volume index is one of the most popular and widely used volume indicators that help in volume analysis. In his book, Fosback clearly explains how the NVI can be used to ascertain trend.
Step 1: Calculate the NVI of the stock you want to trade.
Step 2: Compare the NVI with the 255-day exponential moving average (EMA) of the stock.
If the NVI was above the 255-day EMA, there is a 96% chance that a bull market exists.
If the NVI was below the 255-day EMA, there is a 53% chance that a bear market is in progress.
NVI rises on days of positive price change on lower volume, NVI falls on days of negative price change on lower volume, and NVI is unchanged on days of higher volume no matter what the price action.
A word of caution
Traders need to take caution because it doesn’t mean that the market has become bearish when the NVI goes below the long-term moving average. Instead, this means that the likelihood of the market being bullish has dropped below 50%.
In addition, the NVI is often exposed to whipsaws which when numerous crossovers happen rapidly. This makes it difficult for traders to understand the price movement and the market trend.
Bottom Line
The NVI is more predictable and more reliable than the positive volume index (PVI). It combines both price and the trading volume to track what those with smart and not-so-smart reputations are doing.
The NVI works well with stocks and can provide important insight for day traders seeking to understand the current market trend.
For day traders, it would be wise to add the NVI indicator to the regular market chart you are trading in order to have an overview of what is going on from a far.
It is important to stay at the forefront of a longer-term trend even for day traders and other market participants that focus on trading short-term market movements.
That said, the NVI indicator should not be used alone but combined with other technical analysis indicators to get better market signals.