Unlike other terms coined by technical analysts, volume is self-explanatory. It refers to the number of shares of RIO (RIO Tinto) or ANZ (ANZ Banking Group), for example, traded during the day. The amount of money flowing in equals the amount of money flowing out, meaning that the number of shares bought equals the number of shares sold.
In a nutshell, volume is a measure of trading activity and a tool to gauge the psychology of the market players. Volume can be analysed on many time frames: 15-minutes, daily, weekly or monthly chart. It is usually displayed on a price chart as a histogram at the bottom of the chart.
Why Should You Monitor Volume?
Volume is the fuel behind a market move; it is the petrol in the tank if you wish. Just as your car cannot go much further without fuel, so does a market, cannot advance or decline further without eager participants. Volume is particularly useful when it comes to identifying divergences between the price and shares traded.
If the price and volume disagree, it means that the underlying trend is short-lived and deceiving, therefore not as strong as it seems. Volume could warn of trend reversals as well, since it measures the eagerness on both sides, buying and selling.
Is High Volume Bullish or Bearish?
The answer is: it depends. Generally speaking, where the trend goes, the volume goes to. It is normal for the volume to expand in a rising market, therefore volume only tells us that the two are in sync, and has little forecasting value. However a new price up move that is not confirmed by volume is a divergence, a sign to be cautious.
This abnormality has forecasting value; you should look at it suspiciously at least. Who is trying so desperately to drive up the price and why? Is it short covering? The only time when rising prices on lower volume is regarded as “normal” is when the price recovers after a selling climax.
The opposite is true as well. If a market has risen for many months, an anaemic price rise on high volume is also bearish. High volume could be bearish too if volume expands as prices fall. Therefore, increasing volume means that you are looking at a strong underlying trend. Record volume when a market recovers from a major low is significant too, because it indicates a change in traders’ psychology.
Trend Reversal
How about if both the volume and price increase gradually, but after a while exponentially? When it seems that the stock can only appreciate in value, the shocking thing happens: it falls off the cliff. This represents an exhaustion move and it is characteristic of a trend reversal.
If you follow commodities markets you have probably noticed that metals, especially silver, are prone to this type of exhaustion moves. Climatic volume means exhaustion and that the move is about to reverse, regardless of the direction of the underlying trend. However, determining when the volume or a stock is at their peak can be very tricky in practice. High price and volume does not mean that the move is over; the next day could move the two even higher.
The only comment that I comfortable making is that the odds of seeing a correction are greater.
Volume versus Open Interest
Some technical analysts, especially the ones who follow commodities, also look at open interest. Open interest counts the number of contracts still open in a futures market at the end of the trading day. Open interest is expected to move in the same direction with volume and same rules apply: higher or lower price on heavy volume and open interest means that the trend is strong. If volume and open interest are weak, it means that there isn’t much momentum behind the move.
More on Volume
Some traders want to see the difference between upside and downside volume and they pay attention to the upside/downside ratio. As the name implies, the ratio shows the relationship between the total volume of advancing shares, versus the total volume of declining issues. Other traders noticed that the volume oscillates according to the time of the day.
Typically, the heaviest volume is seen during the first hour-and-a-half of the day and then the last hour-and-a-half of the day. Day traders can use this generality to help them with their intra-day trading decisions. It is believed that the midday quiet session occurs because institutional traders are sitting on the sidelines waiting for heavier volume to execute their trades since increased liquidity means more favourable prices. This is helpful information for day traders as well.
Final Thought
I consider volume just another trading tool. If you are scanning thousands of stocks looking for a good trading opportunity, volume can help distinguish between those that are in a strong up or downtrend. As mentioned previously, stocks with higher trading volume develop more sustainable trends; therefore this screening process can help you weed out the stocks that do not have too much fuel behind them. I also look at volume in context. Just one day of increased volume does not say much, so I analyse the trend of the volume over a period of time.
There are some traders who do not believe that volume is very significant. They view it just as a simple reflection of supply and demand. In their view, higher volume equals more demand while lower volume means less, with no other implications. To some extent I agree with them, because I do not consider volume a stand-alone indicator, but a confirming or supplementary tool. Regardless of the point of view you may have on this one, while you analyse moving averages, Bollinger bands, Elliot waves or so more exotic indicators, why not take a look at volume as well? See what other traders are doing.
