The basic idea behind the development of the LEV/SEV indicator was that after the decimalization, funds started to slice their orders and send them to the market so that they would not be detected by other players. The LEV/SEV statistical algorithm simply measures the volume that is responsible for price changes from one minute to the next. The theory behind is that if one fund wants to accumulate a large position, the LEV pattern will be increasing, simply due to the larger than usual number of buy orders that the fund will have to place. The EV method therefore somehow reconstructs the pattern and direction of the sliced orders.
The hypothesis for tracking funds is that funds have superior financial means to analyse stocks, measure market activity and manipulate prices.
1. Using EV for a very large stock: GOOG
Suppose that a fund wants to invest 20 Million $ in GOOG. This is basically 1% of what the Google stock trades every day. Liquidity is high enough and hence, funds do not need to slice their orders. This liquidity is provided by other large funds. This means that the LEV pattern will mostly follow the price, since no single fund is large enough to bend the price of GOOG. However, there are sometime slight divergences between LEV and price for GOOG. These occur when many funds have a similar behavior. This makes such small divergences very important to trade.
We can see below two typical divergences:
- When the price is in a trading range but LEV trends
- When the price reverses to a support zone but LEV diverges
LEV shows you that something strange is happening and if you often trade GOOG, then you can understand and take advantage of that "something."
For a very large stock, LEV can be a leading indicator.
2. Using LEV for a mid size stock: GRMN
Suppose that the fund decides instead to invest his 20 Million into GRMN. GRMN is very liquid, but 20 Million is about 40% of what is traded in one day. Hence, the fund will have to start slicing his orders (or go to a dark pool, or even ask a market maker to provide the liquidity - meaning manipulate the markets down to get shares.)
This means that you will start seeing many LEV/Price divergences on GRMN, as can be seen below.
How can we use these divergences? Are they meaningful? In fact, these divergences mean that at some points, funds have been selling into a price rise or buying a price decline. However, can we infer from these moves the next price direction?
On Page 300 of the VIT book, I published a main LEV back-test. The Figure below is copied from the book.
What I did was to buy when LEV had been trending up for three days and hold for a few fixed number of days. This strategy was worse than a buy and hold strategy.
However, buying when the LEV had been up for three days AND when the Active Boundaries were signaling cheap prices was a much outperforming strategy.
This means that in the case of a mid-size stock, LEV's leadership is circumstantial. LEV cannot be by itself a leading indicator. I use it to see what traders are doing when we reach a support/resistance level or the Lower/Upper boundaries.
For example, GRMN traders have been selling the price bounce and this selling pattern has become more intense as we failed at the 50MA on Friday. This means that it makes sense to short GRMN, but that a short trade must be closed if GRMN breaks above the 50MA.
3. Using LEV for a small stock: FRO
Today, I received the following message from a recent user of the EV tool:
Hello Pascal,
I've been using the real time EV monitor for a few months now, and had a couple questions (more like seeking your opinion) regarding SEV and LEV patterns. I am an active day/swing trader, and I often buy retracements in small cap stocks or other misc. small cap stocks that I believe have breakout potential. I do not trade OTC stocks, so these are mostly on the larger 3 exchanges.
I've noticed in many cases, for example ticker symbol FRO (referring to EV movement from Nov 19 to Nov 26), that SEV often shows significant accumulation prior to breakouts while LEV moves equally significantly downward.
Another example would be XNPT (prior to break out on Dec 20). My not so developed theory was that the reason for LEV moves downward in that manner is not so much that LEV is not interested in the stock, but that SEV accumulation is met with selling by LEV to keep the price steady. It's almost as though LEV is letting SEV accumulate shares without moving the price up much.
I am question whether this line of thinking has any merit from the viewpoint of both the institutional investor and your theory on effective volume in general. Of course, I am strictly limiting the above line of thinking to the small cap stocks which do not see very heavy volume until they begin breaking out.
FRO was particularly interesting to me, as I noted in my journal on Sunday Nov 24:
E. Wave pattern potentially near completion. Interesting that LEV and SEV are diverging strongly with SEV snatching up shares on what would be the worst area to buy if the chart was weak.
How does this conclude? Give it a couple days for a resolution.
The FRO chart clearly shows the resolution, which was strong and sustained upward movement beginning a couple days after the journal entry on Wednesday Nov 27.
I would enjoy your thoughts about this, and I welcome any criticisms so please feel free to be as forthright as needed.
This I believe is a very interesting question: can we use LEV for very small stocks? FRO trades about 8 Million $ per day. It is a tiny stock for most funds. For example if we decided not to show our hand and invest maximum 5% of the total money traded on FRO each day, our 20 Million $ investment would take almost 50 days. This is not realistic!
There is another aspect of these small stocks: they usually have poor financials, low cash, high debts, high cash burn rate, etc. This means that for them, anything costs and they will need to use (print) free shares to have things done, such as hire a new manager, seal a debt deal, sign a research/marketing agreement. These recipients of free shares will have a tendency to sell shares as fast as possible. Hence, small stocks sometimes (often) have a strange LEV pattern that is often down trending. This pattern has nothing to do with the potential of the company. It has to do with insiders/partners having to sell.
How can we use EV in such conditions? First, the objective of LEV being to spot large funds, it is clear that we are here out of the normal objective. However, there are two ways to use this method:
1. Use TEV (combine LEV and SEV) and see if there is general accumulation or distribution.
2. Use the sector Money Flow (LEV based) in order to see if money moves into the whole sector. Indeed, if a fund wants access to that sector, then money will be spread on all the stocks in that sector. If the sector does poorly, a small stock in that sector will probably do even worse.
For FRO, we can see that there was a large period of TEV accumulation around November and we can see that the related Shipping sector issued a buy signal around that period (at the end of October) followed by a period of very positive MF.
For a small stock, prefer TEV and the MF on the sector.
Conclusions: In general, it is very important to understand what a tool can and cannot do.