When you’re talking to someone, you not only hear what they say, you also watch how they say it. You read tone of voice and body language and other factors to judge whether they’re sincere or not. When you look at stock charts, you can do the same thing by watching the daily trading volume.
The simplest use of volume is just to confirm advances and declines. When a stock is making good progress in price terms, it’s good to see that volume is also up. It confirms that lots of buyers want in. Similarly, when a stock is declining, a parallel increase in selling volume lets you know that sellers are in control.
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There are two special cases of this confirmation principle that are worth mentioning. The first is a decline on triple volume (i.e. a stock’s price is heading down and daily volume is three times its average). The triple volume selloff is a major red flag, a signal that you should consider selling unless the buyers resume control, pronto! Stocks can decline significantly without triggering sell disciplines, but the change of perception that’s indicated by a tripling of selling volume is hard to recover from.
The other special case is the high-volume breakout. Stocks will frequently trade in a range for weeks (or even months) at a time, and this base building process can eventually lead to some strong advances. But to avoid buying too soon, savvy investors will watch for both an advance through the old price resistance level and a confirming increase in trading volume. Such a combination gives you the confidence you need to jump in on the advance.
It’s also possible for trading volume to contradict price actions. When stocks are reaching the end of a rally, they often make a final, rapid advance before rolling over into a correction. And advances like this are often accompanied by a shrinkage in volume as the Johnny-come-lately crowd chases the stock up. At this point, the institutional buyers (whose activity is often indicated by greatly increased volume) are either holding or already starting to head for the door. Savvy investors will often use this pattern as their cue to get ready to sell or, at the very least, to stop buying.
Similarly, when a stock price is heading south, you can use a decline in volume to reassure yourself that it probably won’t be going into freefall. Aggressive investors sometimes use a pullback on light/declining volume as a chance to buy a little more of a stock whose story and fundamentals are still attractive.
The final use of volume is simply to verify that the stock is liquid enough to allow you to trade in and out of it with confidence. Stocks with low trading volume (and low prices, as well) can be very volatile, often enticing you with rip-roaring advances that make your mouth water. But beware! If a stock is trading fewer than 300,000 shares a day, you may have difficulty executing a trade in a timely manner, which could mean buying higher (or selling lower) than you meant to.
Technical analysis is a fascinating business, and one that you can keep learning for years. But these few investing tips on volume will help you to be a better investor … and a better trader.
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