Tue 12, NOV 2024

How Traders Use Volume To Their Advantage

So, first things first, let’s talk about what volume is. Generally speaking, volume is a measure of quantity. In relation to the stock market, volume refers to the number of shares that were traded in any given timeframe.


For example, if Bob buys 300 shares of Tesla, and Alice buys 100 shares of Apple, together the total volume of their transaction is 400. That number gets added towards the daily trading volume of the stock market.


It’s important to note here that it's not the number of transactions that counts as volume, but the total number of units of an asset, such as a share. Also, in the example above, the total volume of stocks that were traded by Bob and Alice is counted toward the entire stock market volume for that day. But, beyond that, both of their transactions had an impact on the trading volume of each company’s shares too. So, when Bob bought his shares, the trading volume for Tesla increased. The same happened when Alice bought Apple shares.


Reading Volume Charts


Although quoting Charles Dow is always a good idea, in this particular case, it’s more than just a good idea – it’s a must. Charles Dow believed that volume is the most important indicator along with price. Why? In short, because volume illustrates the validity behind the price moves.


So, when traders look at the charts, they see candlesticks which help them understand the movement of the price. Is there a bullish or bearish momentum? Is the market indecisive? These are questions that candlesticks patterns can answer. But to answer whether a price move has validity or where the price is likely to go next, volume charts are needed.


Volume is typically found at the bottom of the price chart. It is represented by a histogram, or in simpler words, bars that rise and fall depending on the quantity of volume that there is. These bars represent the number of shares traded per any given timeframe. So, if Bob wanted to see the trading volume of Tesla on a 1-minute timeframe, each bar would represent the volume per minute. Now, let’s say that Alice wanted to see the daily trading volume of Apple, in her chart, each bar would represent the trading volume of each day.


The reason that they are located below the price charts is to make it easier for traders to see how the volume patterns correspond to the price patterns. The more volume there is behind a price move, the more buying or selling pressure there is in the market. On the contrary, less volume implies that there is less buying or selling pressure.


Let’s say, for example, that Alice just bought one share of Tesla for $300. She did this because she saw that the price was increasing, and wanted to take advantage of the rally. However, the share price began to decline soon after she bought it. The problem is that Alice forgot to look at the volume. If she had looked, she would’ve seen that there is not enough volume behind the upward price move. In other words, the asset is probably overpriced and highly likely to see a trend reversal soon.


Essentially, what we’re saying is that volume should increase or climb in the same direction as the price trend. So, when they say ‘volume confirms the trend’ what it means is that in an uptrend, volume ought to climb along with the prices, and fall when the prices dip. Whereas, in a downtrend, volume ought to be higher on the dips, and lighter on the bounces.


Why is Volume Important to Traders?


As long as volume and price patterns move in harmony, traders should feel confident following the trend. However, they should keep an eye out on both the prices and the volume bars. Candlesticks can form many different kinds of patterns, but volume can help traders determine if the pattern is likely to be a continuation or a reversal of the existing trend.


Let’s take the Head & Shoulders reversal pattern as an example.


If during the formation of the pattern the volume from the neckline to the head is lighter, it’s the first sign that the bulls are too weak to maintain the upward direction. The next alert occurs during the formation of the second shoulder, when the prices move from neckline to the right shoulder on lighter volume. Finally, prices decline below the neckline but this time it's on higher volume, confirming the reversal to the downside.
Essentially, this indicates that volume precedes price. It is a leading indicator that can help traders determine whether there is enough pressure in the market to maintain an existing trend.


The Bottom Line


As already mentioned, volume is an extremely important indicator. After all, it's considered a leading indicator that precedes the price itself. It can help traders understand if the direction of the market is weakening or strengthening.


Let’s say, for example, that the price of company XYZ breaks above the resistance level on higher volume. This is a likely confirmation that the price will continue to move upwards. Similarly, if the price fell below the support level on high volume, it would be considered a likely indication that the prices will continue to move downwards.


In a healthy uptrend, volume should increase in the direction of the market and decrease during the declines. Conversely, in a healthy downtrend, volume should increase during the decline and decrease during upward corrections.


If you liked this article, you might also like our articles on Stop Loss, Candlestick Patterns, the Moving Average, and many more. Head over to your account and discover all the educational resources that IQ0PTI0NS offers!