Trading volume, or volume, is the number of shares or contracts that indicates the overall activity of a security or market for a given period. Trading volume is an important technical indicator an investor uses to confirm a trend or trend reversal. Volume gives an investor an idea of the price action of a security and whether they should buy or sell the security.
Trading volume can help an investor identify momentum in a stock 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 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 fundamental analysis of the company and sees 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 may reverse.
This is where trading volume analysis comes in handy. The investor sees there was a steady increase in volume over the past month. They also realize it was the highest volume company ABC experienced over the past two years, and the stock is continuing in the uptrend. This signals to the investor that company ABC is gaining momentum and the trend should continue higher. The increase in volume causes the investor to purchase 1,000 shares of company ABC.
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.
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 but with a decrease in volume. This signals to the investor the bullish uptrend in company ABC is beginning to lose momentum and may soon end.
The following week, shares of company ABC decrease by 10% in one trading day after being in an uptrend for six months. The stock breaks its uptrend and the volume is very high relative to its average daily trading volume, or ADTV. The investor sells out of all the shares the next day because the reversal of trend was confirmed due to the high volume and a decrease in price.