LEVEL: INTERMEDIATE
One of the most popular forms of analyzing the value of securities is technical analysis (TA), which uses statistical theory to assess the probability that an asset price will go up or down. One of the key components of a full technical analysis is volume.
While the momentum of price is very important to determine the future value of a stock from a TA perspective, the actual number of shares traded is also essential. This is what volume is: a measurement of the quantity and size of trades that occur in a given day of trading.
This number can significantly alter our understanding of a stock’s place in the market. For example, a stock price might go down just 0.01 points in a day, signaling a rather slow day of trading. But on that same day, 10 million stocks may have been traded, which would suggest that there is enormous interest in the stock both from buyers and sellers.
This is an important piece to the puzzle when it comes to understanding just how the market perceives a stock. Usually, volume can tell us a lot about three features of the stock: its liquidity, how its price is likely to change in the future, and how much demand there is for the stock.
Volume and the Law of Supply and Demand
As an example, let’s take a look at how shares in Facebook have traded so far for the day, August 7, 2012:
We can see from this that shares in Facebook are trending downwards but are slightly flat, in terms of price: shares are at $21.87, just 5 cents shy of yesterday’s closing price and 33 cents lower than today’s opening price. That’s a loss of less than 1%, which is not too significant. Simply looking at the price, we might conclude that today is not a good day for Facebook, but it could be much worse, and the stock is not headed for a steep decline.
If we look at volume, a different story emerges. In the bottom table, you can see trades arranged by time represented as vertical bars: the higher the bar, the bigger the trade. At the time this snapshot was taken, about 14.2 million shares had been traded. This is about half of the day average of 28 million shares, suggesting that there is less demand for Facebook shares than there had been in the past.
This isn’t necessarily bad, since it could signal that less people want to sell shares than in the past because they expect the stock to go up. It could also mean that there are less buyers looking to invest, which could be a negative indicator for the future value of Facebook.
Volume and Price Changes
It is difficult to make many conclusions from the volume of a stock unless it is combined with external data, and technical analysts will usually pair volume with price changes to predict the future value of the stock. In this case, we see low volume and low price change, but bursts of volume at moments when the stock drops in value.
To most technical analysts, this would not be interpreted as a good sign.
In the case of an appreciating stock, a sudden surge in volume occurring when there is an increase in the price of the stock would suggest that interest in the stock is increasing. Higher demand naturally leads to higher prices, so the stock’s value will probably go up.
In the case of Facebook above, we see that surges in volume seem to happen when the stock falls in price, and increases in price are not accompanied by increases in volume. This suggests that there is declining demand in the stock, less willingness to buy when the stock increases, and more interest to sell when the stock begins to fall in value. All of these signals point to further depreciation of the asset.
A close analysis of volume and price leads to a very different picture than a simple study of just price on its own. If we analyzed just the price of Facebook from the opening bell until 10:30 AM and wanted to make a trade, we might conclude that the stock is showing signs of promise:
But even with this limited amount of information, a close look at volume tells us a different story. Spikes in volume seem to occur mostly when the stock is falling in price, and increases in the value of the stock are not accompanied by higher volumes. This suggests that there isn’t enough demand to sustain increases in price, and that those gains are short lived. It’s no surprise, looking at the volume of shares traded, that Facebook would lose these gains in the next two hours.
Volume and Liquidity
At 14+ million shares traded in a day, liquidity is not much of an issue for Facebook investors unless they are managing a massive portfolio with a heavy Facebook presence.
In some cases, however, the volume of a share can have a major impact on the liquidity of an investor’s holdings. Since volume indicates the amount of shares that are bought and sold, exceptionally low volumes indicate that there just aren’t enough buyers in the market to buy shares. Some companies will see less than 1,000 shares traded in a day. If you hold 100 shares, you will account for 10% of that day’s market of buyers. If you want to sell all of those shares at once, the mere act of trying to sell your shares will lower the value of those shares, because there is suddenly an oversupply in the market.
Even worse still, you might find that no one wants to buy your shares because it is such a small market. In this case, sellers either need to wait, sell only a fraction of the holdings that they want to get rid of, or lower their asking price. None of these options is ideal, so volume is an important indicator to measure just how likely it will be that you will be able to sell shares on the open market if you invest in that particular stock.