Few single metrics mean more to investors than volume. If faith in markets is based on the wisdom of crowds, then trading volume would naturally be an essential signal regarding investors’ belief in a stock or asset. If an increasing number of investors seek out shares of a particular stock, the price of those shares can be expected to increase.
Of course, trading volume is easy to identify after prices have already moved; how can investors find stocks getting a trading volume bump while it's happening? In this article, we’ll look at how trading volume affects assets like stocks, what tools can be used to identify volume changes, and how trading volume can be used in your investment analysis.
What Is Trading Volume?
Trading volume means the total number of shares of a particular stock bought and sold within a specific timeframe, typically a day, month, or quarter. Volume indicates market activity and liquidity, and dozens of technical analysis oscillators use some type of volume metric in their formulas.
For example, let’s say that about 300 million shares of NVIDIA Corp. (NASDAQ: NVDA) are traded daily on average. That’s a lot of shares, but NVDA is a massive company with a nearly $3 trillion market cap. This means that 300 million NVDA shares change hands every single trading session. Now, imagine this volume spikes to 400 million shares on a particular day and remains elevated at around 350 million for the rest of the week. A volume spike like this in a hugely traded company might warrant some due diligence about a potential catalyst since underlying demand for the stock is increasing.
Why Is Trading Volume Important?
Volume and stocks often have a straightforward relationship, but like any relationship, there can be complications along the way. Understanding volume is necessary for trend evaluation, which is why so many momentum indicators use it in their calculations. For example, when a stock price increase is accompanied by high volume, this is often considered a trend confirmation and signals conviction behind the price spike. Low volume during a price spike could indicate a weakening trend or a stock with limited liquidity.
Volume is often accompanied by volatility, which is why so many short-term traders use volume in their analysis. Volatility can lead to substantial price fluctuations within short periods, so day and swing traders often look for volatile stocks to capitalize on these drastic swings. If volatility occurs without much volume, it could indicate illiquidity, which brings us to our next point.
Without liquid markets, pricing securities like stocks becomes difficult, and trading volume will dry up. Highly liquid stocks can have millions of shares traded daily (especially high-flying tech stocks like NVDA) without significantly affecting price in one direction or another. Think of liquidity as oil protecting your car’s engine - it provides a buffer so all the different parts function smoothly and efficiently while also keeping costs (i.e., spreads) down.
How to Read Trading Volume
Seeing an increase in volume is usually a good sign, but as we mentioned above, the relationship between volume and stock prices can be complicated. Here are a few methods for reading and incorporating trading volume into your analysis.
Volume Confirms Price Trends
Volume is heavily utilized in trend-following trading strategies. When a stock’s price rises alongside an increase in volume, it’s known as trend confirmation and suggests that the uptrend will continue. Likewise, if trading volume dries up and the price drops, it indicates a downtrend.
Spotting Volume Spikes
Volume can gradually increase over days or weeks but sometimes spikes almost instantaneously, especially in small-cap stocks with low share counts. Sudden volume spikes in thinly traded stocks should be approached with a skeptical eye. Still, large volume increases in established or reputable companies could signal that a news event or catalyst is about to make headlines.
Identifying Divergences
Divergence is where price and volume change their relationship status to ‘It’s Complicated.’ Sometimes, price and volume move in different directions, and when this occurs, investors must be ready to reset expectations. For example, if a stock makes a new high on low volume, it could signal that the trend is petering out, and a reversal could be around the corner. On the other hand, a stock hitting new lows on minimal volume could be about to bounce.
Volume in Consolidation Phases
Consolidation is when a stock trades in a tight range as investors survey the landscape and await the next signal. Despite this lack of movement, volume can still be helpful in consolidation phases. Low volume during consolidation indicates limited interest in the stock, while higher volume could signal buying or selling pressure under the surface.
Analyzing Volume as Support and Resistance
Certain price levels often act as areas of support or resistance, meaning buyers or sellers tend to present themselves when the stock price reaches a certain point. For example, imagine a stock trading between $8 and $10 in a particular session. When the price reaches $10, volume increases, and the price drops. This signals that the $10 level is resistance, and traders have set orders to sell shares once the $10 price is reached.
How Does Volume Affect Stock Price?
Volume can have an outsized influence on stock prices, but detecting the momentum swing early is the key to making profitable trades. Here are some of the most popular volume indicators and tools used in stock trading, each offering unique insights into the relationship between volume and price action:
- On-Balance Volume (OBV): Measures daily volume changes over a specific period. Volume is added on up days and subtracted on down days. Traders look for divergence to signal a reversal or convergence to signal a continuation.
- Volume Moving Average: This is a moving average like the 50—or 200-day SMA, but it uses volume figures instead of price data. VMAs aim to smooth out volume fluctuations and create a clearer picture of the current trend.
- Volume-Weighted Average Price (VWAP): VWAP seeks to combine price and volume metrics by giving more weight to price data accompanied by heavy volume. For example, if a stock price drops on minimal volume, VWAP views it as less significant than a corresponding uptick in high volume.
- Chaikin Money Flow (CMF): The CMF uses a money multiplier (Closing price - low price / high price - low price) with volume metrics to determine how much money percolates in and out of a stock during a specific period. A divergence between price and CMF could indicate a trend reversal.
- Accumulation/Distribution Line (A/D Line): The A/D line argues that capital flows into a stock when it closes near its daily high and out when it closes near the low. When the price and the A/D line move in the same direction, it indicates a strong trend, while a divergence is interpreted as a reversal signal.
How to Use Trading Volume to Make Investment Decisions
- Assessing Market Sentiment: When volume increases, it often indicates heightened investor interest in that particular asset or security. Volume drops indicate the opposite and could precede a price decline.
- Confirming Trend Continuations and Reversals - In technical analysis, volume is often used to confirm price movements. If a stock jumps 10% on high volume, it likely means there’s some strength behind the movement. Many momentum indicators like VWAP and the A/D Line measure trend strength or spot reversals using volume metrics.
- Identifying Liquid Stocks - High volume means lots of shares are being traded, which also means plenty of buyers and sellers in the market for that particular stock. Liquidity in a stock means that positions can be easily entered and exited with minimal cost since liquid stocks also have lower bid/ask spreads.
When Used Correctly, Trading Volume Helps Identify Investment Opportunities
Do high box office sales pique your curiosity about a movie? The same concept often applies to investing when buyers pour into a stock. Increasing volume means more shares are being traded than usual, indicating a strengthening trend or imminent catalyst. However, while volume is a crucial metric, divergences frequently occur, and volume can’t be used in isolation to make buy or sell decisions. Always use multiple indicators when looking for trading opportunities, and consult with an advisor before making any changes to your investment plan.
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