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Trading XOI Volume

Adam Hamilton
November 14, 2005

With crude oil correcting and driving oil stocks sharply lower last month, investors and speculators are salivating over the awesome potential oil-stock buying opportunity brewing today.

During fundamentally-driven secular bulls which last many years, the major interim lows that mark the ideal moments to buy are relatively rare. On average they probably only occur once every nine months to a year or so over the life of a bull. As such, it is well worth our time to try to anticipate and prepare for these buying opportunities.

In recent weeks I've researched the technicals of both oil and oil stocks , trying to get a read on the probabilities governing both markets and where the potential bottoming points are likely to be. This week I would like to extend my oil-stock studies into the realm of volume. Daily trading volume tends to offer some telltale clues identifying major intermediate reversals within secular trends.

Unfortunately, like in almost all long-neglected commodities sectors, daily trading volume is not recorded for the premier oil-stock index. The Amex Oil Index, or XOI, is an untraded proxy that was designed over two decades ago solely to track the progress of the oil-stock sector. As such, there is no conventional way to analyze XOI volume. Historical and current volume information for sector-tracking indexes just doesn't exist.

Thankfully we have faced this challenge before while analyzing the gold-stock sector in recent years and the solution is not too hard to implement. When a sector index like the HUI or XOI doesn't have any volume of its own, an index composite volume can be constructed. Composite volume adds up the respective daily trading volumes of all the individual index component companies and uses the result as a volume proxy.

In the XOI's case, it currently has 13 component companies all involved in exploring for, developing, producing, and refining petroleum. These range in size from the tiny $12b Amerada Hess to the mighty $360b Exxon Mobil, the world's largest publicly traded oil company. All of these companies' stocks trade every day, they all have volume, and all these volumes can be added together to create the XOI composite volume construct.

Naturally while building the necessary spreadsheets for tracking and adding the individual daily trading volumes of all 13 XOI companies, I dug deep into the index's inner workings. Unfortunately I found something that concerns me as it reduces the utility of the XOI for traders. The XOI, like many older indexes, is price weighted. This means the higher the share price of a particular company, the more weight it is given in the XOI.

Normally price weighting, which is common in index construction, is not a major problem. In most cases the larger and more-important companies often have higher share prices than smaller less-important ones. But in the XOI's case, the smaller and less-important companies now have far higher share prices than the big ones. This allows these smaller companies to unduly influence and distort index performance.

Today AHC, because of its rich $125ish share price, comprises 13% of the XOI by weight even though it is only a $12b company. Meanwhile giant XOM is weighted at under 6% of the XOI even though it is a massive $360b behemoth. The problem is share prices are meaningless, any size of company can have whatever share price range it wants by splitting or reverse-splitting its stock.

A far superior way to weight an index, which is growing more common in newer indexes, is by market capitalization. The market cap for any company is its share price multiplied by its number of shares outstanding. In market-cap-weighted indexes the true total value the market assigns to each company is considered instead of the largely irrelevant share price.

With the XOI's current share-price weighting, its top five components which now command 52% of the index currently only represent about 9% of its total market capitalization. Meanwhile its bottom five components, which only represent 27% of the XOI's weight today, are a whopping 79% of its market capitalization! Small companies not splitting their stocks in a timely manner have led to this anomaly which distorts the XOI's utility.

This current anomaly with the XOI is important for investors and speculators to consider today, and I continue to ponder it myself. Very small oil companies have a vastly disproportionate impact on the XOI today compared to the large majors that truly matter. Until its individual components' share prices are more in line with their market caps or the index's weighting is changed to market-cap weighted, the XOI should be viewed with caution.

Despite these problems, the XOI remains the most popular measure of the oil-stock sector today. If you are aware of an alternative oil-stock index that tracks stocks traded in the US markets and has existed for at least four years, please drop me an e-mail. Since commodities sectors were utterly neglected during the general-market bull from 1982 to early 2000, we have suboptimal commodities tools to work with today. Of course this will change eventually as this commodities bull grows more popular and mainstreamers catch on.

Interestingly the actual XOI composite volume, smoothed with a 5-day moving average to mitigate the periodic daily extremes, wasn't what I expected. In the older gold-stock bull , the HUI composite volume 5dma has generally remained within a well-defined horizontal trading range. While the XOI had a similar range in its bull's initial two years, in 2005 its volume broke out to the upside and hasn't looked back since.

It seems counterintuitive at first, but a sector bull can march higher for many years without composite volume growing. In the XOI's case it blasted 81% higher from early 2003 to late 2004, a very impressive gain, yet composite volume remained fairly stable. For all of 2003 and 2004, XOI composite volume formed a well-defined horizontal trading range generally running between 30m to 50m shares a day on a 5dma basis.

Why is this? As sector bulls climb higher, the share prices of individual component companies rise as well. Where a particular company may have had a $25 stock in the early stages of the bull, it may be bid up to $50 today. Thus a million shares of it traded today versus a million shares of it traded a few years ago represent much more capital changing hands now. Indeed this capital volume concept is useful and is discussed below.

Back to the composite volume charted above, the XOI's volume catapulted out of its multi-year 30m to 50m share range in early 2005. Since then it has run from roughly 50m on the low side to 85m on the high side, a higher range which reflects the enormous increase in general-investor interest in oil stocks so far in 2005. This sustained surge makes the XOI comp volume inhospitable, at least at the moment, to employing a straight horizontal volume trading band like we've done in the HUI.

Despite this unique behavior, the XOI volume has trended. Three volume channels are rendered above, each lasting about a year when XOI comp volume generally didn't stray too far from its particular channel in force. While certainly not as clean as a pure HUI-style horizontal trading band, these XOI volume trends may prove tradable. They are clear enough to flag volume extremes relative to surrounding conditions at any given time.

Trading volume, like most technical indicators, acts as a proxy for the prevailing emotions dominating market thought. But it is intriguing as it is much more situationally dependent than most indicators. In other words, extremely high volume can mark both major interim tops and bottoms. The proper interpretation of these major volume spikes is totally dependent on each one's context.

Very high volume only occurs when people feel really compelled to buy or sell. The ultimate driver of buy/sell decisions is emotion, and both rampant greed around tops and black fear around bottoms amply drive far larger than normal trading volumes. Thus a major volume spike in an upleg that has been running for awhile usually flags an interim top. But the same volume spike in a downleg that is maturing often represents an interim bottom, the ideal time to throw long oil stocks.

Either way, major volume spikes often indicate tradable reversals in short-term or intermediate-term trends. On the other end of the volume spectrum is low volume. Volume lows usually represent malaise or boredom which is why summer trading, even in these charts, usually exhibits the lowest volume of any particular year. During a secular bull, low volume can suggest apathy which is also often a good time to buy.

In light of these volume generalities, can XOI comp volume help today's investors and speculators better time their oil-stock trades? Quite possibly. On both charts this week you will note light green and red transparent bands. Green bands represent major XOI rallies while red bands represent major XOI corrections. Did XOI volume provide clues to help traders buy early in the green bands and sell early in the red? I am particularly interested in this question over the last year or so when the XOI really became volatile enough to trade.

Starting in summer 2004, XOI volume surged on a pullback to the index's 50dma, possibly a sign of a fear-laden selloff. After that volume spike, volume dropped rapidly just as the XOI started to climb in Q3 of last year. As this fast six-week surge matured, volume again spiked, probably on greed, just ahead of its interim top. In this case volume appeared to work as an indicator. Two high-volume spikes representing a correction low and subsequent upleg top sandwiched a low-volume apathy slump.

Another major low-volume apathy slump occurred in early 2005, when we did some oil-stock buying, ahead of one of the largest bull-to-date rallies in the XOI. Volume steadily climbed with the XOI until it spiked up to 85m shares on a 5dma basis as the XOI carved an interim top. Then volume faded as the XOI corrected into Q2 of this year but it suddenly spiked to a new bull-to-date high on fear in the capitulation just before the next major XOI upleg, our most recent.

The early days of this latest XOI upleg were surrounded with low-volume apathy episodes, usually a great time to buy. Summer volume actually remained relatively low until the hurricanes started slamming into the Gulf and then spiked dramatically for obvious reasons. While this spike didn't mark the exact top, it was pretty close and oil-stock speculators would have been well served by selling their positions or shorting right after it.

And just recently XOI comp volume shot up again as the index corrected sharply. While I suspect the index hasn't yet carved a bottom this time around for reasons I explained last week , XOI volume did still spike on fear that oil-stock prices had advanced too fast during the storm chaos. And all the while this year composite volume generally meandered within the third trading range noted above, helping speculators define relative extremes.

Thus in the XOI's case in the past year or so, reality has corresponded with volume theory. Major interim tops and bottoms are usually marked by extreme volume spikes as greed or fear drive abnormally large episodes of trading. Meanwhile low volume episodes are common in the early days of new uplegs when apathy abounds as fear from the recent correction is slowly transformed into growing greed.

In order to trade XOI volume, investors and speculators should be cognizant of whether the XOI is running in upleg or correction mode. If it has been running in an upleg that is maturing, major volume spikes higher above resistance on a 5dma basis are a warning to sell positions, tighten stops, or initiate shorts. If the index has been grinding lower in a maturing correction, major volume spikes often mark the fear-laden capitulation so characteristic of a major low. In this case positions can be bought and leveraged long trades like calls initiated.

A secondary confirmation of a new upleg being underway following a capitulation is low volume episodes. Few investors get excited about new uplegs until they reach new bull-to-date highs and near topping zones. Early on new uplegs are often perceived as nothing more than bounces so excitement, and hence trading levels, is low. During a secular bull, volume apathy occurring soon after a high-volume selling spike is a powerful buy omen.

In light of all this, it looks like XOI composite volume can indeed offer clues to oil-stock trading timing. While probably not precise enough to use as a primary indicator at this point, XOI comp volume certainly offers great secondary confirmations of those tradable oil-stock reversals we all want to catch and capitalize on.

Another way to examine XOI volume, and incidentally both of these methods are not really affected by the XOI's current price-weighting anomaly, is capital volume. As referred to above, capital volume simply takes each XOI component company's daily share volume, multiplies it by that company's daily closing share price at the time, and then adds all the components' results together to get an index volume. This is also smoothed with a modest 5dma to make it easier to chart.

Capital volume shows the actual dollar value of XOI-component companies' stocks trading hands each day as this oil-stock bull gains steam and powers higher. It ought to provide a very pure measure of actual investor and speculator interest in oil stocks that should prove illuminating over time. Interestingly this measure also has three distinct, yet different from comp volume's, trend channels bull to date.

Way back in early 2003 when most folks believed Washington's silly hype that its invasion of Iraq would push oil back under $25 a barrel indefinitely, capital volume in oil stocks was understandably low. On a 5dma basis only about $1.0b to $1.5b worth of XOI oil-stock shares were changing hands daily. This is really pretty stunning in light of how large the oil business is. Investors just weren't interested.

In 2004 XOI capital volume started to grow and created a new uptrend. By the end of the year over $2b worth of XOI-component shares were traded a day. While the index had climbed nicely, general interest in it still remained relatively anemic. All of this changed dramatically as 2005 dawned though, with XOI cap volume suddenly blasting north of $5b while trailing the first major upleg of this year.

This year XOI cap volume has been enormous relative to the rest of the XOI bull. It even briefly exceeded $7b a day on a 5dma basis as greed drove a miniature buying panic in oil stocks as the hurricanes battered the Gulf coast. The two extreme tops in cap volume carved this year form a new upper resistance line that nicely parallels lower support. I will certainly look for future cap volume extremes in the context of this uptrend channel.

Can XOI traders use capital volume as well? I think so. One thing I find really interesting is that XOI cap volume above almost always reaches a new bull-to-date high when any new upleg matures and is topping. A big surge in capital volume up to levels never before seen as an upleg is maturing is probably a good sign that speculators should prepare for a correction. And these cap volume surges tend to be nearly vertical, extremely sharp as euphoria is growing too grand to be sustainable in the XOI.

It's also intriguing that the latter days of the two 2005 corrections, while they did have high capital volume as expected, were not able to meet the capital volume levels of the specific tops which preceded them. One possibility is this occurred merely because share prices were lower in the corrections, so on average each share represented less capital even while similar amounts of shares were traded.

But another possibility is that perhaps the greed near tops is stronger than the fear near bottoms since oil stocks are in a secular bull. In secular bears this inverts, bottoming fear is much more motivating than topping greed. If this idea is correct in the XOI's case, it adds another piece of corroborating evidence that investors are increasingly considering this oil-stock bull the real deal, a long-term secular bull.

In light of these XOI volume explorations, these XOI volume constructs do appear to have value for traders. High volume spikes tend to mark major interim tops or bottoms depending on the context in which they occur, while low-volume episodes are characteristic of the early days of major new uplegs. We will certainly continue monitoring these XOI volume measures at Zeal periodically as this bull moves higher.

With all the technical stars appearing to line up more with each passing week, a major oil-stock buying opportunity seems to be drawing nigh. We are preparing to launch an oil-stock campaign and will recommend the most promising stocks when the technical timing seems appropriate.

All of our upcoming oil-stock trades will be documented and recommended when we launch them in our acclaimed newsletters . Please subscribe today to join us as we attempt to saddle and ride the next major XOI upleg!

The bottom line is XOI volume does offer clues on buy and sell timing for investors and speculators. Regardless of the market, trading volume is driven by greed and fear and the XOI is no exception. Major spikes in oil-stock volume tend to happen near major tradable highs and lows. And low volume episodes tend to mark the early stages of new uplegs when apathy reigns.

Investors and speculators alike attempting to time the major oil-stock uplegs and corrections would do well to periodically consult XOI volume.

November 11, 2005
Adam Hamilton, CPA

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