Understanding the Role of Volume in Stock Trading

It is important to interpret volume correctly because it helps understand price moves and thereby maximize gains and minimize losses.

Volume generally goes with the trend: if a stock is rising, you want to see higher volume on up days; and if a stock is falling, higher volume on down days confirms the downtrend. But some cases are not as clear-cut, although the price and volume action are still very important.

High Volume - Small Move

What does it mean when the volume is huge but the price does not move much?

If the stock has been rising for a while, this may be an early danger signal. As a stock advances, higher prices attract more buyers so the volume generally increases with the price. But sellers - long-term holders and speculators - lurk in the shadows, waiting for the right time to unload their positions at a profit. They need volume for the market to absorb their selling. So when a stock starts trading on high volume without a corresponding price advance, it may be a sign of distribution (professional selling), which is usually followed by a stock price decline.

On the other hand, if a stock that has been falling for a while starts trading on high volume without further price decline, it may be an indication of a bottom: selling is being absorbed by new buying. Once the selling ends, the stock may advance.

Low Volume - Big Move

Every now and then you might encounter a situation in which a thinly traded stock advances with each trade, often on low volume. In professional terms, a stock like this is "hard to buy," meaning that few shares are available for sale. Such a situation can be deceptive and even dangerous.

Every stock has a specialist or market makers - professionals who trade it day in and day out. When you buy a stock, you are often transacting with a specialist or a market maker, not another retail investor. The professionals have a very good feel for the stocks they trade. If they sense the smallest pickup in demand, they start increasing the price with each trade to maximize their profit. Once the buying ends, the price may drop, making low-volume advances unpredictable and dangerous. A seller may also push up the price temporarily on a few trades before unloading a large block on the market.

Low-volume declines can be equally dangerous. A stock price can drop suddenly, scaring you into selling, only to come back up a few hours later. This is a technique often used by professionals to clear out the stops that are under the current market price; or it can be a shakeout - a short-term scare created to shake investors out of their holdings at below-market prices.