HOW IMPORTANT IS TRADING VOLUME

Trading volume, or volume, is defined as the number of shares or contracts that shows the overall activity of a security or market for a specific period. Trading volume is considered an important technical indicator that is often used by investors to identify and confirm trends or trend reversal. Trading volumes also provide a broad idea to investors about price movements or actions concerning security and whether they should hold, buy or sell the securities.

Momentum

Trading volume often assists an investor to identify the momentum in stock as well as to confirm a trend. If trading volume increases, prices move in the same direction. In other words, the volume of security is expected to increase whenever a security is approaching higher in trend and vice versa.

For example, let a company ABC whose price increased by 10% over the last month and an investor is willing to buy 1000 shares of the company and hence conduct fundamental analysis to know about the stability of the company. He goes through earnings, revenues, and notices they have increased too. However, the investor is still in doubt whether a stock will continue the uptrend or will reverse. This is where analysis of trading volume becomes relevant. The investor notices how company’s volume has increased over the last month and the stock is continuing the uptrend as well. It may be the scenario in the analysis that this was the highest volume reached by the company in the last few years. This provides signals that company ABC is gaining momentum and trend is expected to continue higher which eventually provokes the investor to invest in company ABC and buy 1000 shares.

Low Activity

Trading volume also provides signals to the investor regarding buy and sell of securities. That is, it indicates when to take profits and when to sell securities due to low activity. If there happens to be no relationship between trading volume and price of the security, this signals probable weakness in the trend and hence a possible reversal.

For example, let a company be ABC who has extended it uptrend for a further 5 months and increased by 70% in six months. Thus, the investor notices the uptrend in shares and keep onto those shares. However, in the next few weeks, there comes a fall in the volume but stock keeps going in the uptrend. This provides signals of a bullish trend in company ABC and will begin to lose momentum and may end soon. The subsequent week, shares of company ABC decrease by 10% in one trading day after being in an uptrend for six months. The stock breaks its uptrend and the volume remains on high concerning to its average daily trading volume. Thus the investor sells out of all the shares the next day due to the reversal of trend being confirmed because of high volume and fall in price.

Chart patterns

 

Next important use of volume is confirming the chart patterns such as head and shoulders, cup and handle, triangles and more. Since chart pattern help in predicting trends and reversal, without the trading volume, signals provided by chart patterns become unreliable.

Price

The last important concept is that price is preceded by volume. Technical analysts give due observation to the trading volume to interpret the likelihood of reversals, which implies that volume changes can bring changes to the price. If the volume is decreasing in an uptrend, it may provide signal that the uptrend is coming to a close and the likelihood of reversal.