Depicted as a histogram at the bottom of the chart, trading volume is one of the most closely watched indicators next to price. Why is it thought to be so important and how can it be used by traders? Find out the answers to these questions and more below.
What is trading volume? What does it signify?
Trading volume is the number of overall shares traded on a daily basis on a market for a particular security.
In terms of what it signifies, it represents the level of interest in a stock, indicating the sheer amount of buying and selling that is taking place. It also represents the liquidity of the stock, which refers to the ease with which a trader can get in and out of a stock.
How does trading volume affect price?
Volume tends to precede price. This simply means that often volume will increase before a significant move in the stock.
It won’t always as clear as the chart below, but looking at February 28th and May 9th the spike in volume for YouGov was dramatic but it wasn’t until a few days later that the price actually began to move. Such spikes that aren’t based on any set of results or company update should be a flag that institutional money is up to something and to expect the price to make a significant move in the near future.
Why does this tend to happen? Well, to use a popular expression: to throw one small pebble at a window and it probably won’t break; however, throw 100 small pebbles and the chances of it breaking are far greater. Applying this to a stock, if only one investor places a buy order at a given price then the stock is unlikely to hold/move, but if a large number of other investors do the same then it is much more likely to do so.
Based on such logic, technical analysts tend to closely watch trading volume to determine when reversals are likely to occur. For instance, if volume is decreasing in an uptrend, then it could be a signal that the momentum is coming to a close and a reversal could soon take place. Conversely, if the day closes with a large spike in volume in the opposite direction of the trend, then this could be used to signal that the trend is getting ready to reverse.
Associated to this, volume is also useful for determining how strong a move in price really is. To provide an example, a drop in price on little volume would not be considered a strong signal; however, a drop in price on large volume would be considered a strong signal, suggesting that something in the stock has fundamentally changed. Alternatively, a stock appreciating on high volume would be perceived as sustainable, whereas a stock appreciating on low volume would be considered as unsustainable.
So, for instance, take a look at the rally at the start of May for IQE in the chart below. Notice how the volume isn’t that high and it quickly drops off? This could be a signal that the stock is unlikely to move any further up and more likely to carry on its trend of lower lows and lower highs.
Another key indicator for judging the strength of the trend is the level of volume at the point at which the stock moves over or under a previous swing high or swing low. The idea behind this is that in an uptrend if the stock closes over the previous swing high on increased volume then the trend has a higher probability of continuing than if the stock closes on lower volume.
For what reason? Basically, by closing on increased volume, this signifies that buyers were willing to purchase a greater number of shares at a higher price than they had done previously. Therefore, there is greater consensus that the company’s shares should be valued more highly. Alternatively, if the stock had closed over the previous swing high point on lower volume, then the trend would be considered suspect and perceived as possibly being a false breakout.
As way of an example, the chart below shows how at the start of 2018 WAND had twice broken through 800 pence per share but both times had seen its share price fall back down. In March, though, the stock again broke through 800 pence per share but on much greater volume. This time around WAND was able to continue its move upwards, with the previous level of resistance now becoming the support.
An exception to these rules, though, would be the spikes in volume and price associated with significant news events or releases. Such spikes often lead to sharp reversals due to the move being unsustainable – something that is incredibly common on AIM. Admittedly, the news could well put the stock in an up or downtrend, but this often doesn’t take shape properly until a sizeable pullback has firstly taken place.
Are indicators useful when analysing trading volume?
Indicators aren’t actually required but can prove useful at times, with the most useful being the On-Balance Volume (OBV) indicator. The OBV is simply a running total of positive and negative volume, meaning that volume is added when the market finishes higher, or volume is subtracted when the market finishes lower.
With such a simple calculation, insight can be gathered relating to a number of different things, such as:
- During a trading range, if the OBV is rising, accumulation might be taking place – a sign of a potential upward breakout.
- During a trading range, if the OBV is falling, distribution might be taking place – a sign of a potential downward breakout.
- When both the price and OBV are making higher peaks and higher troughs, the upward trend is more likely to continue.
- When both the price and OBV are making lower peaks and lower troughs, the downward trend is more likely to continue.
- When the price continues to make higher peaks but OBV fails to also make higher peaks, the upward trend is more likely to stall or fail (called a negative divergence).
- When the price continues to make lower troughs but OBV fails to also make lower troughs, the downward trend is more likely to stall or fail (called a positive divergence).
Is trading volume important to traders?
Trading volume is a way of helping determine what is really going on behind the scenes. It won’t provide you with all of the answers, but it can certainly help in indicating when a reversal might take place, as well as identifying the strength of the recent movement in share price. This last point when comes to trading on AIM is vital with the share price of lots of companies on the market able to move around on quite low levels of volume. In summary, don’t base your trading on volume alone, but always make sure to check what’s going on compared to the typical range in volume before making any moves into the market.