You don’t have to be involved in the stock market to know the word “volume” carries weight on Wall Street. For the investor that deploys technical analysis to buy and sell, the parameters and implications of this word can be a prime mover into the stock-related decisions they find themselves making every day. Of course, it’s up to the investor to know what these parameters are so that they can be used to their maximum effectiveness.
To put it simply, the term volume refers to the number of shares or contracts that are traded in a market setting over a particular period. This time, frame can have any given parameters, but they are usually cordoned off to one day. Share volume is very formulaic; the higher the volume, the more active the stock.
Technical analysts tend to refer to handy volume bars that are typically conveniently located at the bottom of any given chart. These bars provide an easily digestible visual to how active a stock is via the number of shares that have been traded within a specified period. These bars can also be used to pinpoint trends in a similar manner to how prices can indicate trends.
The Importance of Volume
On the surface, volume’s ability to extrapolate share action can look like a bunch of cool technical data. Even at this initial level, investors can get a good bead on what a stock might be all about. After all, a heavily traded stock is probably going to have some level of financial-related intrigue that’s worth further scrutiny.
But the true value of volume goes beyond the realm of spotting an intriguing company. Savvy technical analysts will mine the data from volume to confirm chart patterns and trends in a way that lets them know the depth of the stock’s action. In a given scenario, a stock that slides ups or down a chart with relatively high volume is considered a stronger, more significant move than one that does the same movement but with weaker volume.
In other words, the volume will give insight to the “why” behind a stock’s movement as opposed to just providing the surface “what.” For instance, let’s say you have a stock that’s been in the throes of a long downtrend. Suddenly, that same stock hops up a whopping 7% after one day of trading. This spike will naturally jump out at the chart reader, but it won’t necessarily provide clues that tie to the leap. But the investor that scrutinizes the volume may be able to glean key information about the ramifications of the spike, such as if it looks to be an indicator of a trend reversal. If the peak coincides with heavy volume, there’s an excellent chance that a reversal is on the horizon. If the volume is lukewarm, then the prospects of a reversal happening aren’t as rosy as the chart line may indicate.
Volume is a critical indicator because it should coincide with a trend. For instance, if a price is steadily moving upward, the amount of volume should follow in kind. If this correlation erodes, trend analysts may take this as a sign of trend weakness. Savvy investors can use this known correlation as a signal that a trend may be coming to an end sooner than later, which could, in turn, spur them to act accordingly.
When volume doesn’t act like it’s “supposed to” in this regard, it becomes known as a divergence. The most basic example of a divergence occurring is when a clear upward trend coincides with declining volume. A divergence is an important indicator for those that deploy technical analysis, as identifying these moments of contradiction can signal a major shift in the direction of a price. These shifts can correlate to prime moments of trading for the technical analyst, depending on what trading strategy they are implementing.
Volume, Chart Patterns, and Price
Without volume to back it up, chart patterns may be reduced to a bit of a guessing game. Familiar looking patterns like triangles, flags or head and shoulders can all have the impetuses behind their movement confirmed by their correlating data, which investors can use to make savvier trades that are based on information more quantitative than the circulation of a squiggly line.
The relationship between volume and chart patterns are specifically critical at specific times. Most of the time, chart patterns will exhibit numerous pivotal points that will pique a trader’s interest. Corresponding volume data at these points will mine important information that lets the trader know whether or not the pattern represents the strength of high-quality trends or the weakness of a deceptive movement.
Additionally, technical analysts will turn to volume to make sure it’s preceding a stock’s price. Because volume can tell a deeper story about a stock’s trend reversal, the movement (or lack thereof) could provide investors clues as to whether a stock price is going to swing upward in a robust fashion or if it’s going to sputter and eventually stall out.
The following Volume Won’t Eliminate Risk, but it Can Mitigate it
Just like everything associated with the stock market, it’s imperative to understand that understanding strong indicators of stock performance like volume will not turn jumping into the market a risk-free proposition. The market is still prone to unusual odds and ends that may catch even the most seasoned investor off-guard. This may be especially true of those that deploy tactics associated with technical analysis, as they tend to use short-term tactics that put stock patterns into a vacuum as opposed to those that prefer long-term tactics.
Still, understanding the correlation that clearly exists between volume and chart movement can be an important component to help minimize risk. The link between the two entities provides investors with insight into predictability, which could, in turn, lower the instances of them making relatively uninformed decisions based on incomplete data. And in the world of investing, cutting down on regrettable decisions is every bit as important as making the right call.