If you ever look at the volume leaders for the trading day, you almost always will find Bank of America Corp. (BAC). On a day in late May, trading volume for BAC totaled 70,026,719. The three-month average is even higher: 75,194,900. Those are big numbers, but where do they come from, and what do they mean? (For related reading, see: Why You Should Understand the Stock Market.)  

The first part of the question can be answered with ease: market exchanges. The second part requires a little more detail. If you’re a retail investor, read on. While volume is only one tool of many, it adds value to your investing decision. (For related reading, see: Five-Minute Intro to Investing.)

How it Works

Calculating volume is simply the total amount of shares traded for the day, which includes both buy and sell orders. You can determine the daily trading volume on your own — all transactions are publicly available — by calculating the total amount of shares traded. However, it’s much easier to look at the daily trading volume on any stock chart. Time is money, after all, and it would be wise to save time. Daily trading volume shouldn’t be confused with dollar volume, which is a stock’s share price times its daily volume. (For more, see: Understanding the Ticker Tape.)

Why it Matters

If you see a stock that’s appreciating on high volume, it's more likely to be a sustainable move. If you see a stock that’s appreciating on low volume, it could be a dead cat bounce. Logically, when more money is moving a stock price, it means there is more demand for that stock. If a small amount of money is moving the stock price, the odds of that move being sustainable are lower. Also, be careful of low-volume (or illiquid) stocks, where you could end up trapped in a pump and dump scheme. Even if you were trying to play the artificial move, you might not be able to find a seller if the volume is low and you'd be locked in to a losing trade. (For more, see: The Risks of Trading Low-Volume Stocks.)

There is one exception for buying low-volume stocks, which is when you have done your due diligence and concluded that you have found a good company that has yet to be discovered. In this scenario, you would have gotten in ahead of the curve. When volume increases, you will have the potential for a multi-bagger, which is every investor’s dream scenario. (For more, see: Essential Strategies For Trading Volume.)

Another reason to steer clear of most low-volume stocks is the bid-ask spread. With illiquid stocks, the bid-ask spread is going to be wide, which can be costly. A high-volume stock, such as the aforementioned BAC, often has a tight bid-ask spread of a penny, which should do you minimal to no harm. (For more, see: Using Bid-Ask Spread to Choose Stocks.)

When you look at daily trading volume, don’t just look at the trading volume for that particular day. This could be a small-cap stock that popped or dropped on news. In most cases, this won’t be sustainable. Instead, look at the three-month average daily trading volume, which will give you a much better idea of whether the stock offers liquidity. (For more, see: Top Small-Cap Stocks for 2015.)

If you’re on the hunt for high-volume stocks, then you might want to begin with the New York Stock Exchange (NYSE) or Nasdaq. These exchanges have stricter requirements than other exchanges, which is a positive because it keeps the riff raff out of play. Keep in mind, however, that the market as a whole has been on a thinly-traded bull run for years. This could present more risk than a traditional bull market. (For more, see: The NYSE And Nasdaq: How They Work.)

The Bottom Line

Calculating volume is easy. Understanding what volume means is more important. While this should never be the only factor when weighing an investment or trading decision, it always should play a role. (For related reading, see: Top Stocks High-Frequency Traders Pick.)

Dan Moskowitz does not own any shares in BAC. 

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