Trading volume is the total number of shares of a security that were traded during a given period of time. Trading volume is a technical indicator because it represents the overall activity of a security or a market. Investors often use trading volume to confirm the existence, or a continuation, of a trend or trend reversal. Essentially, trading volume can legitimize a security's price action, which can then aid an investor in their decision to either buy or sell that security.
- Trading volume is the total number of shares of a security that were traded during a given period of time.
- Investors often use trading volume to confirm the existence, or a continuation of a trend or a trend reversal.
- Trading volume can signal when an investor should take profits and sell a security due to low activity.
Trading Volume and Momentum
Trading volume can help an investor identify momentum in a security and confirm a trend. If trading volume increases, prices generally move in the same direction. That is, if a security is continuing higher in an uptrend, the volume of the security should also increase and vice versa.
For example, suppose company ABC's stock increased in price by 10% over the past month. An investor is interested in the company and wants to purchase 1,000 shares. They conduct a fundamental analysis of the company and see that its earnings and revenues have consistently increased over the past year. However, the investor is not confident the stock will continue in this uptrend and is worried that the trend may reverse.
In this example, trading volume analysis can be very useful. The investor sees there was a steady increase in ABC's trading volume over the past month. They also notice that the trading volume was the highest that ABC stock had experienced over the past two years, and that the stock is continuing to trend higher. This signals to the investor that ABC is gaining momentum and gives them confidence that the trend should continue higher. Thus, the increase in trading volume led the investor to purchase 1,000 shares of ABC stock.
Trading Volume and Price Reversals
Trading volume can also signal when an investor should take profits and sell a security due to low activity. If there is no relationship between the trading volume and the price of a security, this signals weakness in the current trend and a possible reversal.
For example, suppose company ABC extended its uptrend for another five months and increased by 70% in six months. The investor sees that share prices of company ABC are still in an uptrend and continues to hold on to the shares. However, over the next few weeks, the stock continues in the uptrend. However, the trading volume is decreasing. This could signal to the investor that the bullish uptrend in ABC stock is beginning to lose momentum and may soon end.
The following week, shares of ABC stock decrease by 10% in one trading session after being in an uptrend for six months. This move lower results in the stock breaking its uptrend trend. More significantly, the trading volume spikes higher when compared to its average daily trading volume (ADTV). The investor sells out of all the shares of ABC the next day because the combination of a sharp drop in price and spike in trading volume confirmed that the uptrend might be coming to an end and a reversal might be in the offing.