When a trader or investor calls up a price chart on a trading platform to perform analysis for the purpose of making a trading decision, most platforms will usually include a volume indicator along with price. If a survey among successful traders is taken that asked what are the most important factors that influence a decision to execute a trade, there’s a very high probability the one of the top three factors will be volume. For any tradable asset, in any market, high volume, or the lack of it, reveals some very obvious and sometimes subtle characteristics of the asset that are very important to traders.
On its surface, the volume indicator is very straight forward. It indicates how many shares, contracts, or tokens (in the case of cryptocurrencies), have been traded for the period represented by each price bar. On some trading platforms, the indicator can be configured to indicate the number of transactions (individual trades) completed, as opposed to the quantity of the asset traded. The chart below shows a sample of Microsoft stock (MSFT) with a volume indicator.
Daily Chart: Microsoft (MSFT)
A quick glance at the volume indicator can give a trader a good indication of the liquidity available in the asset’s market. This is important for several reasons. First, a trader needs to ensure the asset being traded has sufficient volume to handle the size of the trade being considered. For example, a small individual online trader that trades a personal account for their Individual Retirement Account (IRA), should not have a problem making smaller sized trades of a few lots. However, a portfolio manager for a large investment institution that intends to either initiate or liquidate a very large position in a stock numbering in the millions of shares, has to consider the amount of slippage that will result from a lack of volume in the particular stock. Price slippage happens when volume is very thin.
Second, if a trader is utilizing an automated algorithmic trading strategy to trade a specific asset, the amount of profit per trade that can be made is limited by the liquidity of the particular asset. For example, if a stock is traded with an algorithm, and a trading signal directs a buy order for 100 shares a $50, the trader should have no problem filling that order at $50. However, as the trading size increases, price will begin to slip away. Consequently, an order for 100,000 shares at $50 in a stock with thin volume may result in an average fill price of $55 (or worse). All the while, the computer algorithm is assuming a price of $50. The same thing will happen when exiting the position. A trader must take this phenomenon into account when developing the trading algorithm, and the size of the trading blocks that will be traded. When using an automated algorithmic trading strategy, the optimal trading size, and therefore potential profit, is a function of the asset’s volume. And there is an inverse relationship between the two.
Daily Chart: Microsoft (MSFT)
An in-depth analysis of volume patterns can reveal some insights about the prevailing market sentiment. For example, closer analysis of the same daily chart above for Microsoft shows the volume spikes are happening when the stock dips during an uptrend. This can be interpreted as traders feeling bullish and looking to get into the stock on price dips.
Volume is also commonly used to confirm technical indicators. For example, if an asset is approaching a resistance level and breaks above it with weak volume, chances are that price will not follow through as a breakout. If the breakout is accompanied by strong volume, then a valid breakout is highly probable. The completion of price patterns like triangles and head-and-shoulder reversals are also examples of where traders look out for strong volume to validate their conclusions. The bottom line is that effective technical analysis requires a minimal amount of volume in order to have sufficient validity to trade with confidence.