How to Use Stock Volume to Improve Your Trading

Trading volume is a measure of how much a given financial asset has traded in a period of time. For stocks, volume is measured in the number of shares traded. For futures and options, volume is based on how many contracts have changed hands. Traders look to volume to determine liquidity and combine changes in volume with technical indicators to make trading decisions.

Looking at volume patterns over time can help get a sense of the strength of conviction behind advances and declines in specific stocks and entire markets. The same is true for options traders, as trading volume is an indicator of an option’s current interest. In fact, volume plays an important role in technical analysis and features prominently among some key technical indicators.

Basic Guidelines for Using Volume

When analyzing volume, there are usually guidelines used 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 offer general guidance for trading decisions.

1. Trend Confirmation

A rising market should see rising volume. Buyers require increasing numbers and increasing enthusiasm to keep pushing prices higher. Increasing price and decreasing volume might suggest a 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.

2. 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 signals 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 by using the other volume guidelines.

3. Bullish Signs

Volume can be 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, on the move back lower, the price doesn’t fall below the previous low, and if the volume is diminished on the second decline, then this is usually interpreted as a bullish sign.

4. 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, then this might indicate that a reversal is underway, and prices will change direction.

5. 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 a lack of interest and a higher probability for a false breakout.

6. Volume History

Volume should be looked at relative to recent history. Comparing volume today to volume 50 years ago might provide irrelevant data. The more recent the data sets, the more relevant they are likely to be.

Three Volume Indicators

Volume indicators are mathematical formulas that are visually represented in the most commonly used charting platforms. Each indicator uses a slightly different formula, and traders should find the indicator that works best for their particular market approach.

Indicators are not required, but they can aid in the trading decision process. There are many volume indicators to choose from, and the following provides a sampling of how several of them can be used.

1. On-Balance Volume (OBV)

On-balance volume (OBV) is a simple but effective indicator. Volume is added (starting with an arbitrary number) when the market finishes higher or subtracted when the market finishes lower. This provides a running total and shows which stocks are being accumulated. It can also show divergences, such as when a price rises but volume is increasing at a slower rate or even beginning to fall.

2. Chaikin Money Flow

Rising prices should be accompanied by rising volume, so Chaikin Money Flow focuses on expanding volume when prices finish in the upper or lower portion of their daily range and then provides a value for the corresponding strength.

When closing prices are in the upper portion of the day’s range, and volume is expanding, values will be high. When closing prices are in the lower portion of the range, values will be negative. Chaikin Money Flow can be used as a short-term indicator because it oscillates, but it is more commonly used for seeing divergence.

3. Klinger Oscillator

Fluctuation above and below the zero line can be used to aid other trading signals. The Klinger oscillator sums the accumulation (buying) and distribution (selling) volumes for a given time period.

The Bottom Line

Volume is a handy tool to study trends, and as you can see, there are many ways to use it. Basic guidelines can be used to assess market strength or weakness, as well as to check if volume is confirming a price move or signaling that a reversal might be at hand. Indicators based on volume are sometimes used to help in the decision process. In short, while volume is not a precise tool, entry and exit signals can sometimes be identified by looking at price action, volume, and a volume indicator.