Trading volume is a very powerful tool in capital markets but is often overlooked because it is such a simple performance indicator.
Trading volume information of a security can be found anywhere. However, very few investors know how to use this information to increase their profits and minimize risk in the markets.
In this article
Definition of trading volume
In the financial markets, the word trading volume is the amount or the total number of financial asset that has been traded during a given period of time.
The financial asset can be stocks, bonds, options contracts, futures contracts, and commodities.
In the stock market, for every buyer, there exists a seller, and each transaction between them contributes to the count of total trading volume.
When a buyer and a seller agree to make a transaction at a certain price in the stock market, it is considered one transaction.
If only 10 transactions occur in the entire trading day, the volume for the day is 10.
You can watch the trading volume for any stock for any time period like daily, weekly, monthly or intraday.
Usually, in charts, each price point will have a certain trading volume shown under it which shows how many stocks were traded at that price.
The significance of trading volume
Using trading volume to analyze stocks or any other financial asset can support investors to maximize profits and also reduce risk.
Let’s look into the importance of the trading volume in stock markets:
1. The strength of market movements
In a rising or falling stock market, we can see exhaustion moves in prices.
Trading volume is an important indicator used to measure the relative significance of such market movement.
If the markets make a strong or downward price movement, then the strength of that movement depends on the trading volume for that period of time.
The higher the trading volume during the price movement, the more significant is the move.
2. Market momentum
Trading volume can help investors in identifying momentum in the stock market and confirm a trend. A rising stock market should see the rising trading volume.
The increasing price of stocks and decreasing trading volume show a lack of interest in the market, and this is a warning of a potential reversal.
A price drop on large trading volume is a stronger signal that something in the stock market has fundamentally changed.
3. Bullish signs
Trading volume is very useful in identifying bullish signs in the market.
Imagine trading volume increases on a price drop and then the price moves higher, followed by a move back lower.
If the price on the move back lower stays higher than the previous low and trading volume is diminished on the second decline, then this is usually interpreted as a bullish sign in the stock market.
4. Price – Volume analysis
When you look at the stock price and its trading volume separately, it is just a number.
When you analyze trading volume together with stock price, volume helps to understand the processes behind a price trend in the market.
Such a price-volume analysis may tell you:
- how strong price trend is,
- whether money is pumped in or money is pulled out,
- whether big institutional traders are dumping or accumulating.
5. Sign of low activity
Trading volume can also signal when an investor should take profits and sell stock due to low activity in the market.
If there is no relationship between the trading volume and the price of a stock, this signals weakness in the current trend and a possible reversal.
Say a company X extended its uptrend for another six months and increased by 60% in six months.
The investor sees that stock prices of company X is still in an uptrend and continues to hold on to the stocks.
However, over the next few weeks, the stock continues in the uptrend but with a decrease in trading volume. This signals to the investor the bullish uptrend in company X is beginning to lose momentum and may soon end.
The following week, shares of company ABC decrease by about 10% in one trading day after being in an uptrend for six months.
So, the investor sells out of all the stocks the very next day because the reversal of trend was confirmed due to the high trading volume and a decrease in stock price.
The Bottom Line
In any capital market, price and time are the only things that investors care about.
Certain low profile parameters, like the trading volume as such, may not be an attractive piece of information to most. But many investors do manage to use it to their advantage in the markets to gain returns on their investments.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.