In order to be a successful stock investor and trader, you need to understand what trading volume is and how it affects stock prices.
Trading volume measures the number of shares that have been traded (i.e. either bought or sold) over a specific period of time. Understanding how this metric impacts stock prices can help you make more informed investment and trading decisions.
In this blog post, I’ll talk about why trading volume is important to keep an eye on, how it affects stock prices, and how you can use it to your advantage.
Why Is Trading Volume Important To Keep An Eye On?
There are a few reasons why trading volume is important to monitor:
1. It can give you clues about the future direction of the stock price.
If the trading volume is increasing while the stock price is going up, it’s a good sign that there’s strong demand for the stock and that the price is likely to continue to rise. On the other hand, if the trading volume is increasing while the stock price is going down, it could be a sign that the stock price is about to drop even further.
2. It can help you confirm trends.
If you see that a stock price is starting to trend upwards, but the trading volume is relatively low, it could be a sign that the trend isn’t as strong as it appears to be. However, if the stock price starts trending downwards and the trading volume increases, it’s likely that the downtrend is indeed strong and will continue.
3. It can give you an idea of how volatile a stock is.
If a stock typically has a high trading volume, it tends to be more volatile (i.e. the price moves up and down more dramatically). This can be both good and bad, depending on your investment goals and the quality of the stock itself.
4. It can help you spot potential opportunities
If there’s a stock that you’re interested in but it’s not moving much, you might want to wait until the trading volume increases before buying it. This could mean that there’s about to be some movement in the stock price (up or down) and you could potentially make a profit from it.
An Example of Trading Volume Affecting Your Decisions
Sometimes, despite there being a good opportunity to buy a stock (i.e. all the financials and timing indicators line up), it actually isn’t a good time to buy.
This is because contrary to what most people believe, the listed ‘price’ of a stock that you see on sites and platforms such as Yahoo Finance and your online broker is NOT the actual stock price — it is simply the price at which the most recent transaction occurred — also known as the Headline Stock Price.
This means you have to be careful before buying into a stock, even if everything indicates a buy signal – because the Headline Stock Price may not be accurate due to low trading volume.
To illustrate this with an analogy, imagine that on most days:
- Stock A has 100,000 transactions take place
But on one particular day (let’s call that Day X),
- Stock A only has 15 transactions.
It’s much harder to believe that the price reflected on Day X is the true price because there aren’t as many transactions backing it up, which means this price doesn’t truly reflect the real price, and could very well pull back the next day or so.
It’s much easier to believe a stock price is stable and be certain it won’t deviate too much if there is a much higher volume of transactions behind it.
This is the primary reason why investing in penny stocks is dangerous, and why we prefer the bigger end of town of the US market — penny stocks don’t have a lot of transactions backing up their stock price, and the largest companies have a large amount of volume flowing in and out every day.
How Can You Use Trading Volume For Your Investments and Trades?
Now that we know what trading volume is and why it’s important, let’s look at some ways you can use it for your benefit:
1. Check The Volume Before You Buy or Sell
Before you buy or sell any stock, always check the volume to ensure there is enough activity to make your trade worthwhile. A good rule of thumb is to make sure there are at least 100,000 shares traded per day, but ideally, you want to see closer to 1 million. If you stick to large cap companies such as those from the S&P500 in the United States, this won’t be an issue.
2. Monitor The Volume During Price Changes
If you see a significant change in the price of a stock (up or down), always check the volume to see if there are enough trades behind the move to make it worth your while.
3. Compare The Current Volume To Average Volume
If you’re looking at a stock that you’re thinking of buying, always compare the current volume to the average volume. If the current volume is significantly higher or lower than usual, it could be an indication that something is happening with the stock and you should pay attention.
4. Use Volume To Confirm Breakouts and Breakdowns
If a stock is breaking out to new highs (or lows), you want to see an increase in volume to confirm that the move is legitimate. Similarly, if a stock is breaking down from highs (or lows), you want to see an increase in volume to confirm the move.
NOTE: Trading Volume Must Be Accompanied By Other Research
While trading volume is an important indicator, it is not the only factor that you should consider when making investment decisions.
It is essential to thoroughly research any company before investing in its stocks, such as:
- Its financial strength, stability and growth projections (i.e. Fundamental analysis)
- Whether it’s a good time to enter the market or not (i.e. Macro-Analysis)
By using these metrics along with trading volume, you can make well-informed investment choices that are likely to result in profits while preserving your capital.
If you’d like to learn how my students and I do that, I’d like to invite you to join me in my next LIVE Online Masterclass. It goes for 90 minutes, and in it, I’ll be sharing:
- 4 must-have stock criteria that can help you identify the financially strongest stocks in less than 5 minutes and shorten your stock research process
- My 30-second ‘traffic light’ process that I use to know when I can invest and trade confidently, when to start being cautious, and when I absolutely must stop trading.
If that’s of interest to you, you can click to register for your seat here.
I’ll see you, on the other side 🙂
Terry
