A strong understanding of volume is a good addition to price analysis skills. It can help an investor identify momentum in a stock and confirm a trend
Although one of the most underrated and overlooked technical parameters, volume is one of the most important metric an investor must get a grip of while predicting stock price movements. As with most indicators, volume, too, works with them and it is crucial to know what volume is, why it is important in stocks and how best it can be used.
Volume basically is the total number of buyers and sellers exchanging shares over a particular period of time, usually a day. When the volume is high, traders are interested in dealing in that particular share and vice versa. Data on volume of a share is readily available on charts or the trading screen. If volume of the stock for the day was 10,00,000 shares, it means that amount of shares were sold and bought by someone on that particular day. When is information on volume useful? It may not be of any help unless it is combined with data on support and resistance levels, which in turn give a clear picture.
Let us consider a stock ABC, which broke a resistance level and moved upwards on a given day. If the volume traded on that day is four lakh shares, whereas on any normal day, the trading volume is 11 lakh shares, this means that the movement upwards of resistance level may not sustain and the stock price may fall as the resistance breakout was not supported by volume of shares traded. But if the stock has broken the resistance with volume, it may move further up. This is the importance of “volume.” Traders do not buy the stock unless it breaks a critical level with high volume. So any breakout of critical support and resistance level does not sustain unless they are supported by high volume. For any trend to continue, it should be supported by an increase in volume.
Let’s take another example to understand the importance of volume. Suppose a buyer places a market buy order after hours for 50 shares of stock. The transaction occurs at one rupee above the closing price. Therefore, the one rupee price move had 50 shares worth of interest from a buyer. Suppose another buyer places a buy order for 500,000 shares of the stock. This transaction takes place at a price that is one rupee above the current price. Since they both increase the last transaction price by rupee dollar, does that mean that both transactions are bullish in nature? If a trader didn’t use volume, he/she would think that the move was identical. However, the second example is more bullish because the amount the buyer of 500,000 shares is willing to pay is significant. The buyer is willing to take a large bet whereas in the second example, 50 shares are insignificant.
An investor can analyse the weakness or strength of any price movements based on volume. Although this may not be true for all cases, volume data can give guidelines and help in trading decisions. Although increasing volume is important in interpreting stock price trends, extreme increases in volume along with extreme rises or falls in price can sometimes be interpreted opposite to regular volume analysis. Sharp increases in price and volume both can mean bulls have been exhausted — all buyers have bought and there is no one else but sellers and the result is bearish. Sharp decreases in price and sharp increases in volume can mean that everyone, who wanted to get out of the stock or future has and, therefore, there are only buyers left, which is a bullish sign.
As discussed, volume is used to confirm trends and chart patterns and the strength of any price movement. It plays a major role when confirming chart patterns like triangles, head and shoulders and flags among others. If volume isn’t present with these chart patterns, then the trading signal isn’t reliable. Technical analysts closely analyse the volume to see when reversals are about to occur. If volume is decreasing in an uptrend, then it can signal that reversal may take place soon. A rising market should have increasing volume. Buyers should keep the prices moving high. Increasing price and decreasing volume is a warning for a potential reversal. Price rise or decrease on little volume is not a strong signal whereas a price rise or decrease on large volume is a strong signal. On the initial breakout from the range or chart pattern, a rise in volume indicates strength in the move and a little change or decline in volume on a breakout indicates false breakout.
A strong understanding of volume is a good addition to price analysis skills. Being able to see when price increases or decreases, having firm support or knowledge when either buyers or sellers have been exhausted, might prove useful when trading.
(The writer is Assistant Professor at Amity University)