The number of shares bought and sold each day in any given financial instrument, known as volume, is one of the most accurate ways of gauging money flow. For those who are new to the markets, money flow is used by traders to determine the overall supply and demand characteristics or a financial instrument in an attempt to predict its future direction.
High volume suggests that there is a heightened interest in the name, and if it is combined with a move higher in share price, then it is often used as a signal of strong upward momentum. Keeping an eye on volume will ensure that you are on the right side of the trade. Each of the indicators discussed below uses volume as the primary input and will give you a practical view on how to incorporate volume into your trading strategy.
Taking a Closer Look at Volume
Taking a look at the chart of Delta Air Lines, Inc. (DAL), shown below, you can see a huge spike in volume on Sept. 10, 2013, thanks to an announcement that the company would join the S&P 500 stock market index. The strong move higher in the stock price, combined with a spike in volume, suggested that there was renewed interest in the stock and marked the beginning of a strong move higher.
In general, it is best to align a strong surge in volume with a strong shift in the company's fundamentals. In the case of Delta, the addition to the S&P 500 suggested that large index funds and mutual funds would be adding positions. That would add a layer of underlying demand that would push prices higher. Screens for spikes in volume would have brought this stock to the attention of active traders.
The on-balance volume indicator, commonly referred to as OBV, is used to find stocks that have been experiencing sharp increases in volume without a significant change to stock price. When institutional investors start buying shares, one of the goals is to refrain from pushing the price higher so that they can keep their average entry price as low as possible.
This is where the OBV indicator proves extremely useful. Before diving into an example, it's important to note that the indicator is calculated by adding volume to the previous OBV value when the most recent closing price is greater than the previous closing price. If the closing price is lower than the previous close, then the volume is subtracted from the previous OBV value. Now, let's look at an example:
As you can see from the chart of Microsoft Corporation (MSFT), the price trended sideways between $34.80 and $37.00 in late 2013 and early 2014. Notice how the OBV indicator was trending sharply higher during this period. The increasing OBV suggests that traders were becoming bullish on the stock, and a stock screen for rising OBV values would have allowed active traders to get in early before the rise to $41.11.
Volume by Price
Another common strategy that uses volume is to utilize the volume by price indicator. In most cases, volume is plotted at the bottom of a chart as shown in the examples above. In the case of volume by price, it is plotted on the vertical axis so that a trader can get an idea of the volume traded at various price points. Levels with extreme volume can be used to identify areas where the smart money has decided to actively pursue a position. Strong volume moves at key price points are often used by active traders to identify key areas of support and resistance and can generate strategic buying/selling signals when combined with other indicators.
As you can see from the chart of AmerisourceBergen Corporation (ABC), most trading during 2014 occurred between $71.50 and $73, as identified by the volume by price indicator (blue bar used to illustrate the key trading range). In the event of a broad market sell-off, traders would expect the stock to find support near $73. Notice how there was little volume between $74 and $76 because of the gap. Traders would expect little support from buyers between these areas in the event of a pullback.
The Bottom Line
Volume is one of the key indicators used by active traders for gauging money flow. As you've seen in the examples above, indicators that are derived from using volume such as on-balance volume and volume by price can be used to create lucrative trading strategies. It's often a smart idea to combine trading signals generated by changes in volume with a shift in a company's fundamentals. Simple stock screens that identify securities with sharp changes in volume are great candidates for traders looking to create a watch list.