Why Trading Volume Matters

by Michael Barton on November 14, 2012

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Not enough traders or investors pay the attention they should to trading volume.

Traders who trade with a market making strategy – those that buy and sell shares all day, every day – rely on volume for their business model, of course. Price volatility gives them a spread at which to buy and sell, making a profit, but if they can’t do this in big enough size then costs will eat into profits and turn the trade from a gross profits into a net loss.

Even traders who hold positions for a few days or longer – predominantly swing traders – need volume to make a trade pay. Buying stock when volume is high because of a corporate buyer in the market, for example, is easy. Selling the position out when the volume collapses can be an impossible task.

The best stock traders watch volume as an indicator of interest in a stock, and also for impending trend endings.

About Price and Volume

Let’s think about the effect of price on your investment decision before we consider volume. An old stock market saying is ‘price is everything’. Of course, it’s true that when looking for value in the market, the first thing you may examine is price. After all, market valuation is a simple equation of shares multiplied by price. Investment valuation is somewhat different. If the market values a stock below your independently researched and calculated valuation, then the stock is a buy.

However, when looking at price trends, the speed and size of price change is highly important. A stock may seem undervalued, but if the price is moving down, and the size and speed of the downward lurch is increasing, perhaps you need to revisit your valuation? Could the market be right and you wrong?

Stocks can, however, move up and down in little volume, and the price movement be exaggerated because of this. Then, when a buyer or seller of a sizeable order enters the market, the trend could stop, or even reverse.

By examining associated volume with price movement, real relative value may be better considered and optimum buying and selling prices measured.

Another rule of thumb that traders often follow is the one that says ‘volume follows the trend’. In general, as a stock price moves positively, buyers are encouraged into the market, generating a further upward move and increasing buying interest accordingly. Further volume increases follow as the share price moves up.

The same is true of a down trending share price: as the price falls, so sellers move into the market and push the price down further with volume increasing.

Traders look for increasing share trading volume to confirm market trends.

And this brings us to our third volume rule: decreasing volume is generally a sign of an impending price trend reversal. For example, as the price of a share increases, buyers come into the market sending volume and price up. But, at some point, the attractive relative valuation of the stock wanes because of its price. Volume decreases and sellers begin to hold the upper hand. Then the rising price trend reverses.

Volume is a valuable indicator to the investor and trader

Many investors neglect the use of volume as a component of value. But let’s consider a company in which you are interested in investing. You’ve conducted your research, and like the look of the shares at the current price, which has been falling for a few days. Perhaps the fall in the share price alerted you to possible value in the first place?

You decide to buy shares. After all, it’s a long term trade, and you are happy with the price you are paying versus the valuation you have calculated.

For a few days the stock continues to trade down, but the trend eventually reverses and your investment moves into profit. It was the share price fall that led you to believe the stock was undervalued, and you have been proved right.

Now consider if you had also taken note of the associated volume with the share price move. When you bought shares, volume was still increasing: perhaps if you had waited, until volume showed signs of weakening, then your investment would have been better timed?

Watch for volume spikes, too

When considering the timing of an investment, also look at spikes in volume, particularly in a stock that is trending down. A large surge in share volume in a falling market is often seen when investors holding the stock finally bow out, not willing to accept any more pain. It’s the panic mentality of getting out at any price to preserve what is left and avoid further losses. It is usually quoted as the capitulation phase, and can present the very best time to buy, though if you miss the bottom, don’t worry too much: capitulation is often followed by consolidation.

A period of price consolidation will see shares trade in a tight range, with lower volumes. Traders and investors are digesting recent activity and price movement, holding the stock range bound before breaking out to the upside or downside. This break is often preceded by a further spike in volume at the top of the range (the resistance level) – in which case the shares may be about to move higher – or the bottom of the range (the support level) – in which case the shares will be ripe for a further move down.

The importance of volume to you, the investor

Traders use volume as an important indicator of trend reversal to make short term gains. Investing is, naturally, a longer term philosophy. But an investor who learns to incorporate examination of trading volume into buying and selling decisions may well increase his long term performance by several percentage points. For a dividend reinvestment investor, for example, the saving of a few points on the buying price will impact compounded performance throughout the term of the investment, for years to come. And this could mean financial goals being more quickly reached.

Perfect market timing is a summit rarely reached, but better timing is within the capability of all investors. Adding trading volume into your equations of timing will improve your portfolio performance.

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This post was written by...

– who has written 16 posts on Excess Return.

Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites, either in his own name or ghosted.

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