Volume in Trading – Explanation and Interpretation

Volume in trading – explanation and interpretation

You will learn about the following concepts

  • What is volume and how is it visualized?
  • How to interpret volume?
  • High volume and low volume

What is volume and how is it visualized?

Teacher-iconVolume represents the number of stocks, futures or options contracts, which are traded during a certain period of time, most often a day. The higher the volume, the more active the instrument we are trading is. Every unit of volume in any market reflects the actions taken by two sides: one trader buys a given share or contract and another trader sells a given share or contract.

It can be displayed on a price chart in many ways. Some traders prefer to examine volume separately from price action, while others have managed to integrate volume statistics into the price chart. Volume is usually visualized in the form of vertical bars, which inhabit the bottom of any chart. These bars show the total amount of volume for a specific period. If we use daily charts in order to trade, then each volume bar will show the amount of volume on the corresponding trading day. Changes in volume reflect how buyers and sellers react to changes in prices. Changes in volume also indicate if a trend is likely to continue developing or to reverse. Comparing volume in two different markets gives the idea which one is more liquid. Slippage in liquid markets is usually considerably less compared to that in low-volume markets.

Volume is usually measured in one of the following three ways:

First, the exact number of shares or futures (options) contracts that are being traded. This is how the New York Stock Exchange (NYSE) reports volume;

Second, the exact number of trades that are being active. This is how the London Stock Exchange (LSE) reports volume. However, this method fails to differentiate between a trade of 150 shares and a trade of 1500 shares;

Three, tick volume represents the number of price changes during a specific period of time, for instance 1 hour. Most changes equal one tick. Day traders use tick volume as a proxy of intraday volume.

How to interpret volume?

When volume is dropping, this indicates that the number of traders holding losing positions in the market is decreasing, while the trend is about to reverse.

volumeWhen volume is extremely high, this also provides clues that the trend is coming to an end. It indicates that lots of traders with losing positions are bailing out. A commonly seen situation is a trader, holding a losing position for longer than he/she should have and at some point, when the loss becomes intolerable, he/she decides to exit the market. Once he/she gets out, the trend reverses and the prices go in the direction he/she expected. This occurs, because inexperienced traders show similar reaction to stressful situations and bail out at almost one and the same time. Professional traders, on the other hand, exit losing positions fast and reverse or simply wait for a suitable opportunity to re-enter.

When trading is in a range, volume usually remains low, because traders seem to be indecisive about market direction. The eventual breakout from the trading range occurs, accompanied by a massive increase in volume, as losing traders are in a hurry to exit. If the breakout occurs on low volume, this signifies that traders show little emotional commitment to the new trend, while the market is likely to return into the range.

When volume is rising during a market rally, this implies that increasing number of buyers and sellers are lured into the market. Bulls are anxious to go long, even if they have to pay a higher price, and bears are eager to sell to them. Increasing volume also indicates that losing traders, who exit the market, are replaced by other losing traders.

When volume is decreasing during a market rally, this implies that buyers are growing less anxious to act, while sellers are no longer looking to cover. Cunning sellers have already made their exit from the market, followed by low-capacity sellers, who could not afford to lose more. Decreasing volume indicates that there is no more fuel to sustain the bull trend and a reversal is probably at hand.

lowWhen volume dries up during a downtrend, this implies that sellers are less anxious to go short, while buyers are no longer looking to exit the market. Cunning buyers have already closed their positions and low-capacity buyers have been flushed out. Decreasing volume also indicates that buyers with still active positions probably have a higher level of tolerance for losses. They could probably afford to lose more, or went long at a later time during the downtrend, or both. Decreasing volume outlines an area, where the bear trend may reverse.

High volume and low volume

For any market, in case volume is 25% and more higher than the average volume during the past two weeks, it is referred to as “high volume”. In case volume is 25% and more lower than the average volume during the past two weeks, it is referred to as “low volume”.

High volume provides confirmation that a trend is still active. In case the market reaches a new peak and volume increases to a new high, it is likely that the market may test again or surpass that high.

In case the market reaches a new bottom and volume marks a new high, it is likely that the market may test again or surpass that bottom. A climax low is usually retested when volume is low. This provides a trader with the opportunity to go long.

In case volume declines while the trend continues, this trend is probably set for a reversal. If the market reaches a new peak on lower volume compared to the prior peak, a trader will usually look for an opportunity to go short.

Volume during reactions against the underlying trend also needs to be examined. When a bull trend is followed by a drop, volume usually increases, as market players are anxious to take profits. When the drop in prices continues, but volume also drops, this is an indication that buyers are no longer active or selling pressure is spent. When volume plays out, this shows that market reaction is almost over and the bull trend is poised for resumption. This reveals an opportunity for a trader to go long.