Trading Volume Analysis: A Must-read for Beginners

Trading Volume Analysis

Trading volume plays a vital role in technical analysis as it helps confirm trends and patterns. In addition, trade volume analysis is a method to understand how other participants discern the market. It reflects the number of shares bought and sold in a given period. 

Trading volume refers to the number of shares of given security transacted in a given period. It indicates the activities in the market and liquidity of a given security. It suggests that the market is very active, implying that it is easy for market participants to execute transactions. In such a scenario, trading volume increases. Likewise, when a security is traded less actively, its trading volume is interpreted to be low.

Why trading volume is important for traders?

When there is uncertainty over the future trend of the financial markets, their trade volume tends to rise. Consequently, options and futures trading gets more active.

Traders employ trading volume as one of the components in technical analysis when they evaluate market trades. It is a beneficial yet simple tool in massive price jumps or drops. Conversely, a high trading volume can work as a stimulus in drastic price rises. When a high trading volume is correlated with such changes, faith in the security’s real value gets strengthened. 

Trade volume levels can also assist traders in deciding on particular times for trade. For this, they track a security’s average trading volume daily over a short duration or a longer duration. Generally, trading volumes rise towards the start and end of a trading day and on Mondays and Fridays, being the start and end of the trading week.

Expression of average volume

All financial markets and exchanges track their trading volumes and give volume data. This data can be recorded once every hour throughout a trading day, which is considered an estimation. Likewise, if recorded at the end of a trading day, it is also an estimate. The actual figures are made available the next day.

Average daily trading volume (ADTV) has been the most broadly used timeframe for computing stock volume. ADTV refers to the average volume of shares traded in a day of a given stock. Daily volume implies the number of shares traded each day but can be averaged for a certain number of days to determine the average daily volume.

The average volume is an essential metric because a high or low trading volume draws in various types of market participants. Many market participants prefer a higher ADTV to a low ADTV because, with a higher volume, it is simpler to go into and out of positions. On the other hand, low-volume assets attract fewer buyers and sellers. So, an entry or exit at the desired price may be difficult.

Alternatives to trading volume

Traders can also track the tick volume of a stock, which denotes the number of changes in its price. This is because, as the trading volume rises, the changes in price also get more frequent.

The tick volume assesses every trade and the volume associated with those trades for a given period. The tick volume analysis aids a day trader or a short-term swing trader in studying the market on an intraday basis.

Example of trading volume analysis

The following table is an example to make you understand how volumes sum up on a trading day:

trading volume table

At 9:30 AM, 400 shares were exchanged at 62.20. An hour later, 500 shares were exchanged at 62.75. At 10:30 AM, the total volume for the day would be 900 (400 + 500). Likewise, 350 shares at 63.10 were exchanged at 11:30 AM. Up to 11:30 AM, the volume was 1,250. This continues in the same manner.

The image below shows the live market highlighting the volumes for some of the shares. The image was taken around 3:15 PM on the 17th of February 2022.

NSE Volume table

(Image credits: Equity Stock Watch, National Stock Exchange)

As you can see above, the Oil and Natural Gas Corporation (ONGC) has a volume of 2,46,19,000 shares. Likewise, the volume of Reliance Industries Ltd (Reliance) is 59,27,000 shares. The volume information here is the cumulative volume. This means, at 3:15 PM, a total of 4,20,69,000 shares of Oil and Natural Gas Corporation were exchanged at various price points varying from 168.50 (low) and 172.40 (high).

As 15 minutes are left for the markets to close, the trading volume can be expected to rise. Here is an image was taken at 3:30 PM for the same set of stocks.

Nse trading volume 2

(Image credits: Equity Stock Watch, National Stock Exchange)

As you can see above, the Oil and Natural Gas Corporation volume has increased from 2,46,19,000 to 2,46,40,000. Thus, for Oil and Natural Gas Corporation, the volume for the day is 2,46,40,000 shares. On the other hand, the volume for Reliance Industries Ltd has increased from 59,27,000 to 59,32,000, making 59,32,000 shares as the volume for the day. Therefore, the volumes shown here are also cumulative.

6 Fundamentals for Using Trading Volume

When assessing volume, some fundamentals are used to determine the strength or weakness of a trading decision. As a result, traders are inclined to engage in stronger trading decisions and not in weak trading decisions. Or, they may even look for an entry in the opposite direction of the weak trading decisions.

These fundamentals give general guidance for trading decisions.

1. Trend Confirmation

An increasing market should see increasing volume. Buyers need increasing numbers to keep on increasing prices. Increasing price and decreasing volume might lead to a lack of interest, which is an indication of a possible reversal.

An increase or decrease in price for a small volume is not a strong signal, whereas that for a large volume is a stronger signal, indicating that something in the stock has drastically changed.

2. Exhaustion Moves and Volume

In an increasing or decreasing market, sharp moves are seen in price and a sharp increase in volume, indicating the possible end of a trend. These moves are called exhaustion moves. Market participants who waited and are apprehensive of losing more of the moves amass at market tops, exhausting the number of buyers.

Decreasing prices ultimately remove numerous traders at a market bottom, leading to volatility and increased volume. Of course, after the increase, the volume decreases in these situations, but how it continues to play in the following days can be assessed using other volume fundamentals.

3. Bullish Signs

Volume analysis can help recognise bullish signs. For instance, assume that on a price decrease, the volume increases, and then the price increases, followed by decreasing back. Now, if the price doesn’t decrease more and the volume is reduced on the second decrease, this is a bullish sign.

4. Volume and Price Reversals

After a long price move, if the price starts to vary with slight movement and heavy volume, this indicates that a reversal might occur in the future, and the prices will change direction.

5. Volume and Breakouts vs False Breakouts

After the early breakout from a chart pattern, an increase in volume suggests strength in the move. Conversely, a minor change in volume or decreasing volume on a breakout suggests a lack of interest and a higher possibility for a false breakout. 

6. Volume History

Volume should be looked at in comparison to recent history. Comparing the volume of the present day to the volume 50 years ago might provide insignificant data. The more recent the data sets, the more pertinent they are.

Which Volume indicators to follow?

Volume indicators refer to mathematical formulas visually depicted in generally employed charting platforms. Each indicator uses a little different formula, and traders should find the indicator that serves best for their market approach.

Indicators are not needed but can help in making trading decisions. For example, among many volume indicators, the following gives an idea of how they can be utilized.

1. On-Balance Volume (OBV)

OBV indicator for trading volume

The on-balance volume (OBV) is a helpful and straightforward indicator. Volume is added, beginning with an arbitrary number, when the market closes higher or deducted when the market closes lower. This gives a running total and shows the stocks that are being collected. It can also indicate a deviation or trend reversal, such as when the price increases but the volume increases at a sluggish rate or even decreases.

2. Chaikin Money Flow

Chaikin Money Flow indicator for treading volume

Increasing prices should be accompanied by increasing volume. Therefore, Chaikin money flow points to increasing the volume when the prices close in the upper or lower portion of their everyday range and then gives a value for the respective strength.

When closing prices are in the upper portion of the everyday range and the volume increases, the values will increase. Whereas, when closing prices are in the lower portion, the values will be negative. Chaikin money flow can be utilized as an indicator for short-term investment strategy because it oscillates but is generally used for identifying deviations.

3. Klinger Oscillator

Klinger Oscillator for trading volume

Variations above and below the zero line can be utilized to assist other trading signals. For example, the Klinger oscillator sums the accumulation (buying) and distribution (selling) volumes for a given duration.

Read more: Technical analysis indicators

Volume trend table

As tabulated above, the volumes for Oil and Natural Gas Corporation are 2,46,40,000 shares. But, the volume information in isolation is relatively meaningless. However, when you connect the present day’s volume information with the preceding price and volume trend, volume information becomes significant.

In the table below, you will find an overview of how to utilize volume information:

As mentioned in the first line of the table, there is a bullish expectation when the price and the volume increase. To get the reference to this increase, you should know that most traders compare the present day’s volume over the average of the last 10 days’ volume. The general rule of thumb is as follows:

High Volume = Today’s volume > last 10 days average volume

Low Volume = Today’s volume < last 10 days average volume

Average Volume = Today’s volume = last 10 days average volume

Reasoning Behind The Volume Trend Table

Institutional investors don’t exchange-traded funds in small amounts. Their large transactions reflect in volumes, and the share price also goes up. Generally, institutional money is called “smart money”. Smart money is always perceived to make smarter trading decisions in the market than retail traders. Therefore, following smart money looks like a bright investment strategy.

An increase in the price and the volume means that a prominent participant is interested in the stock. Going by the belief that smart money always makes smart choices, the expectation becomes bullish. Therefore, one should seek buying opportunities in the stock. Following this, make sure that the volumes are considerable whenever you decide to buy. This implies that you are buying with smart money.

What happens when the price increases but the volume decreases, as denoted in the 2nd row?

If institutional investors were buying, the volumes would have increased, not decreased. The price increased because of small retail buyers, not influential buying. Being cautious would help as this could be a possible bull trap.

The 3rd row states that a price decrease in volume increases leads to a bearish expectation. Why?

A price decrease suggests that market participants are selling the stock. A volume increase suggests the presence of smart money. Both events happening simultaneously indicate that smart money is selling stocks. Considering the same belief (smart money always makes smart choices), the expectation is bearish. Therefore, one should seek selling opportunities in the stock.

Next, what happens when the volume and the price decrease, as shown in the 4th row?

If institutional investors were selling, the volumes would have increased, not decreased. The price decreases because of small retail buyers, not influential selling. Being cautious would help as this could be a possible bear trap.

Referring to the framework

For example, assume a trend of a bullish engulfing pattern near the support area. This trend implies a strong demand for stocks, and therefore, investors can consider buying the stock.

The trader has a double confirmation to trade with an identifiable candlestick pattern and support near the stop loss. With support near the low, there would be a high volume on the 2nd day of the bullish engulfing pattern. This certainly means a high volume and price increase validate that significant and influential market participants want to trade the stock.

All three independent variables, which are candlesticks, support and resistance, and volumes, propose taking the same trading decision, which is to go long. This is a triple confirmation.

As trading volumes help traders ascertain a trade, it is a significant component and must be incorporated in the framework. So, the updated framework includes:

  • The stock should form an identifiable candlestick pattern.
  • Support and resistance should confirm the trade.
  • Trading volumes should authenticate the trade.

The Bottom Line

Trading volume is a valuable component to explore and assess trends. The fundamentals can be taken into use to evaluate market strength or weakness and also to analyze if the trading volume is ascertaining a price move or not. Sometimes, trading volume indicators are used to assist in making the trading decision. In short, entry and exit signals can be recognized by discerning price actions, trading volumes, and volume indicators.

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