How to Use Volume to Improve Your Trading
Volume is a measure of how much of a given financial asset has been traded in a given period of time. It is a very powerful tool but is often overlooked because it is such a simple indicator. Volume information can be found just about anywhere, but few traders or investors know how to use this information to increase their profits and minimize risk.
For every buyer, there needs to be someone who sold them the shares they bought, just as there must be a buyer in order for a seller to get rid of his or her shares. This battle between buyers and sellers for the best price in all different time frames creates movement while longer-term technical and fundamental factors play out. Using volume to analyze stocks (or any financial asset) can bolster profits and also reduce risk.
Basic Guidelines for Using Volume
When analyzing volume, there are guidelines we can use to determine the strength or weakness of a move. As traders, we are more inclined to join strong moves and take no part in moves that show weakness – or we may even watch for an entry in the opposite direction of a weak move. These guidelines do not hold true in all situations, but they are a good general aid in trading decisions.
Volume and Market Interest
A rising market should see rising volume. Buyers require increasing numbers and increasing enthusiasm in order to keep pushing prices higher. Increasing price and decreasing volume show lack of interest, and this is a warning of a potential reversal. This can be hard to wrap your mind around, but the simple fact is that a price drop (or rise) on little volume is not a strong signal. A price drop (or rise) on large volume is a stronger signal that something in the stock has fundamentally changed.
Fig 1 Source: www.freestockcharts.com
A GLD daily chart showing rising price and rising volume
Exhaustion Moves and Volume
In a rising or falling market, we can see exhaustion moves. These are generally sharp moves in price combined with a sharp increase in volume, which signal the potential end of a trend. Participants who waited and are afraid of missing more of the move pile in at market tops, exhausting the number of buyers. At a market bottom, falling prices eventually force out large numbers of traders, resulting in volatility and increased volume. We will see a decrease in volume after the spike in these situations, but how volume continues to play out over the next days, weeks and months can be analyzed using the other volume guidelines.
Fig 2 Source: www.freestockcharts.com
A GLD daily chart showing a volume spike indicating a change of direction.
Volume can be very useful in identifying bullish signs. For example, imagine volume increases on a price decline and then the price moves higher, followed by a move back lower. If the price on the move back lower stays higher than the previous low and volume is diminished on the second decline, then this is usually interpreted as a bullish sign.
Fig 3 Source: www.freestockcharts.com
A SPY daily chart showing a lack of selling interest on the second decline.
Volume and Price Reversals
After a long price move higher or lower, if the price begins to range with little price movement and heavy volume, this often indicates a reversal.
Volume and Breakouts vs. False Breakouts
On the initial breakout from a range or other chart pattern, a rise in volume indicates strength in the move. Little change in volume or declining volume on a breakout indicates lack of interest and a higher probability for a false breakout.
Fig 4 Source: www.freestockcharts.com
A QQQQ daily chart showing increasing volume on breakout.