Why is volume important in stock trading? There is a straight and simple answer to this question – volume is important because it shows the strength of price movement. Like with most price phenomena in the stock market, we are concerned with changes rather than steady states so changes in trading volume are important signals.
This article looks at examples of changes in trading volume under different price movement conditions and draws general lessons and conclusions.
What is volume
Volume is usually taken to mean the number of trades in a stock in any one trading day. We talk about stocks that are thinly traded, if the volume is comparatively low and stocks that are heavily traded if the volume is comparatively high.
In fact some stocks and ETFs have consistently high trading volume and others have consistently low trading volume. Let’s remember though that trading volume is just the number of shares traded in any one day. There is another measure called dollar volume which is the number of shared traded multiplied by the price.
High volume examples
Among the companies whose stocks consistently trade with high volume are some major household names.
Bank of America Corporation, symbol BAC had an average daily trading volume of 81,891,232 and an average daily closing price of $25.29 in June 2020. Here is what that looks like.
1)Data source for all charts Yahoo Finance, or ETrade. Charts and calculations were prepared by https://badinvestmentsadvice.com/
General Electric Company, symbol GE had an average daily trading volume of 103,510,318 and an average daily closing price of $7.21 in June 2020 and this is what that looks like on a chart.
Apple Inc is one of the leading mega-cap stocks of the technology sector which has itself been leading the market advances of recent years. Apple Inc, symbol APPL had an average daily trading volume of 35,851,786 and an average daily closing price of $345.81 in June 2020. Here is the chart for Apple Inc in that month.
To make a bit more sense of these we should put the price and volume statistics into perspective.
Dollar volume with respect to market capitalization
In June 2020, Bank of America average closing price was $25.29 and the average daily volume was 81,819,232, so the dollar volume was $2,070,908,366 which equates to around 0.97% of its market capitalization of $213,420,000,000.
General Electric Company, with an average closing price of $7.21, daily volume of 103,510,318 meant a dollar volume of $746,273,401 which is around 1.19% of its market capitalization of $62,454,000,000.
In comparison, Apple Inc. had an average closing price of $345.81 daily volume of 36,851,786 so a dollar volume of $12,743,582,115 which is around 0.75% of its market capitalization of $1,694,000,000.
So those large and very large-cap companies all trade with a volume that results in a dollar volume is around 1% of the market capitalization. Let’s take a look at an actively traded small-cap stock.
Calyxt Inc. symbol CLXT is a small biotech company involved in gene splicing plants mainly for agricultural purposes. It is one of those small biotech companies working with genome splicing or CRISPR technology which is one of today’s ‘hot topics” for investors. It has a market capitalization of $150,665,000. In June 2020. Here is the chart of its share price and volume in June 2020.
In June 2020 Calyxt Inc had an average daily volume of 83,841 and an average closing price of $5.19 meaning an average dollar volume of $435,211 which is just 0.29% of its market capitalization of $150,665,000. On the thinnest day of trading the volume was just 23,300.
This highlights a potential problem with small-cap stocks, Trading volume can collapse. So even if your crystal ball works wonders and you jump into a small-cap that appreciates nicely, you still need to know that on the other side of the gain there will be enough liquidity for you to get out.
The generally accepted wisdom regarding small-cap stocks is to look at average volume over a good three-month period. The definition of a small-cap stock is not fixed. I have found it wise to be careful with anything below about $150 million in market capitalization though most brokerage houses would consider that to be already micro-cap.
Volume – a recent example
To take a closer look at trading volume, here is a chart of the price of the State Street Global Advisors fund that tracks the Standard and Poor’s 500 index, pr S and P 500 for short by the symbol SPY for the period July 2019 through to mid July 2020.
As many of us know, through 2019 we saw the market steadily climb to a peak on 19 February 2020. The S and P 500 reached 3,386.15 and SPY closed at $335. Both then dropped dramatically to a low on 23 March 2020 when the S and P 500 reached a low point of 2,191.86 and SPY closed at $222.
What is interesting is noting the trading volume that accompanied these dramatic price swings. Let’s take a look at SPY for a five-year period prior to mid-July 2020. Here is what that looks like.
It is interesting to note the patterns in trading volume. It brings us to the main point of this article.
If upward price movement is accompanied by increasing trading volume then that shows that the upward movement is strong and is likely to continue.
If on the other hand there is an upward movement in price and the daily trading volume starts to decline, that shows a weakening price trend and may indicate that a trend reversal is on the way. We can see this on both charts at the 19 February 2020 peak. The daily volume on the SPY dropped noticeably lower just before the market tanked.
We are looking at the 5-year chart as well to put the daily volume in February 2020 in context. Going back 5 years we can see that the even though the index was in new highs the volume would still shrink noticeably in February 2020. Here is a closer look at that exact period.
If we look back at the average daily volume over different periods for the SPY this is what we see.
- July through December 2015, average volume 132,180,889
- January through December 2016, average volume 104,724,339
- January through December 2017, average volume 70,457,158
- January through December 2018, average volume 97,164,471
- January through December 2019, average volume, 70,032,142
- January through 19 February 2020, average volume, 62,732,615
Noting that the SPY hit its all time high on 19 February 2020, with weak volume the subsequent price collapse seems justified.
Volume compared with MACD and RSI
Let’s take a look at the SPY for the same period, comparing the price movement with volume, the Moving Average Convergence Divergence, or MACD for short and the Relative Strength Index or RSI for short.
I know that wisdom in hindsight is easy and this is only looking closely at one single price movement but I do think it is fair to note that the drop in trading volume at the price peak was a strong signal, confirmed a few days later by the MACD crossing over its signal line.
As regards the RSI, this is more valued as a limited indicator of continuation of a price movement rather than indicating a reversal. In fact, it was suggesting that the SPY was already overbought in December 2019 and January 2020.
Answers to common questions
- Why does volume matter in stock trading – the strength of volume is an indicator of the strength of price movement.
- How does volume affect trading – if volume is increasing traders expect the price movement to continue. If volume is decreasing traders expect the price movement to weaken and reverse.
- Is volume good or bad for stock trading – volume is an indicator of whether price movement will continue or reverse.
- What happens when stock volume increases – when stock volume increases, price movement whether trending up or trending down is likely to continue and strengthen.
Here is a single-page summary of this article. It is available for download here.
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|1.||↑||Data source for all charts Yahoo Finance, or ETrade. Charts and calculations were prepared by https://badinvestmentsadvice.com/|