Using Trading Volume to Understand Investment Activity

Investors analyze trading volume when deciding whether to buy or sell a security

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 continuation of a trend, or a 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.

Key Takeaways

  • Trading volume is the total number of shares of a security traded during a given period of time.
  • Investors often use trading volume to confirm a trend's existence or continuation, or a trend reversal.
  • Trading volume can provide investors with a signal to enter the market.
  • Trading volume can also signal when an investor should take profits and sell a security due to low activity.
  • Use volume in context with other indicators, rather than alone, to gain insight into trend direction and the timing of trades.
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Volume

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 that 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, 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, the share price of ABC stock decreases by 10% in one trading session after being in an uptrend for six months. This results in the stock breaking its upward 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.

Use Volume For More Trading Insight

  • High or increasing volume in an uptrend can signal a buying opportunity.
  • Decreasing volume in an uptrend may suggest that it's time to sell and take profits.
  • High or increasing volume in a downtrend can signal that it's best to stay on the sidelines.
  • Decreasing volume in a downtrend may indicate a coming reversal and a time to buy.
  • More involved chart patterns, including the head and shoulders and the flag and pennant, use volume to confirm trends, reversals, and breakouts.


What Is a Good Trading Volume?

Good trading volume for a security is hard to define because trading volume's value comes into play when looked at in context with other indicators, such as price direction and volatility. Any level of volume that provides investors with specific insight into a security's price action (and a sense of the trading interest in that security) can be thought of as a good trading volume.

What Does High Trading Volume Mean?

High trading volume (relative to past measures of that volume) that accompanies rising prices or an upward trend can signal strong interest in a security by buyers. On the other hand, high trading volume that accompanies dropping prices or a downward trend can signal worry on the part of investors. This can result in more selling and even lower prices. High trading volume could also reflect some isolated news or event related to the company associated with the stock.

Is Low Volume Bullish or Bearish?

Trading volume is defined as the number of shares traded in a particular period of time. So, low trading volume can indicate a lack of interest in either buying or selling. That means it could be bullish if low volume occurs in a downtrend. It could be bearish if it's noted in an uptrend.

Article Sources
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  1. Charles Schwab. "Trading Volume as a Market Indicator."

  2. Fidelity. "Turn Up the Volume on Stocks."

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