Negative Volume Index

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Introduction

The Negative Volume Index (NVI) tracks price data on days when trading volumes (total number of transactions in an asset) show declines when compared to the previous day.  The central idea behind the indicator is that when volume is high, the “uninformed” majority is pushing the current trend higher in a bull market (or lower during a bear market). This activity from the unsophisticated section of the market is a reversal signal as the trend is likely to be at its exhaustion point. Conversely, during days of low volume, the “smart” money is thought to be moving into positions that will define the next wave of trend activity.

Essential Assumptions

Paul L. Dysart is credited with inventing the indicator in 1936, using studies of bull and bear markets that were preceded by exchanges in trading volume. In the case of the NVI, market behavior was characterized by declines in volume when compared to historical averages. According to Dystart, this type of activity will indicate the beginning of a new trend in prices. Later, Norman Fosback added revisions to Dystart’s principles and defined the future interpretations of the NVI indicator.

Indicator Interpretations

In today’s trading environment, the NVI is plotted against (oftentimes in conjunction with the Positive Volume Index) a 255 day exponential moving average (EMA). The significance of the number 255, in this case, is that there are 255 trading days in a calendar year. According to Fosback, when the NVI crosses above the 255 period EMA, there is a 95% probability that a bull market is in its initial phases. Conversely, the probability of a bull market drops to 50% when the NVI falls below its 255 period EMA. With this in mind, we can see that the NVI is much more accurate in forecasting bull markets. Because of this, short sellers typically do not rely in this indicator.

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Calculations

The calculations for both the PVI and NVI are generated using comparisons of volume levels from the current and previous sessions.
Using 100 as a baseline (in both the PVI and NVI), current volumes that are larger than volumes in previous session are shown in the PVI. Calculations for the NVI are based on the previous NVI value.
When the Current Volume Level is lower than the Previous Volume Level, the formula is as follows:

NVI = Previous NVI Value + [((Current Closing Value – Previous Closing Value) / Previous Closing Value) * Previous NVI Value]

When the Current Volume Value equals the Previous Volume Value, we revert to the previous values:

NVI = Previous NVI Value

Combining Indicators

Historical research shows that the NVI has a high level of accuracy in predicting bull markets (when the indicator is above its moving average). But we should keep in mind that when the NVI is combined with the Positive Volume Indicator (PVI), traders can have an edge in forecasting bear markets as well. A negative cross in the NVI suggests a roughly 50% chance that a bear market is in its early phases. When the PVI indicator makes the same cross, that figure jumps to above 65%. Since trading is essentially an exercise in turning the probabilities into our favor, we can see that a combination of indicators will enhance forecasting accuracy. Although, it should be kept in mind that this practice will also reduce the number of trading signals that are generated.

Conclusion

In summary, the NVI gives traders an objective indication of when the “smart money” is entering the market and starting to build positions. Conversely, times of high trading volume presents a reversal signal as the previous trend is likely to be over-extended. Indicator readings show buy and sell signals when the NVI crosses above or below its 255 period EMA. The NVI tends to have more predictive accuracy in bull markets than in bear markets but when this indicator is combined with the PVI, the odds of forecasting bear markets are significantly higher.