Stock Trading Volume Basics

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Trading Volume is really quite an interesting and complex subject. This being the case, I often find it somewhat difficult to talk about it in pieces, as I almost feel obligated as one point is covered to lead into the next. You could actually read volumes on the subject, no pun intended! Today however, we'll cover just the basics. How to read a plain old volume histogram and determine the possible future direction of the price and strength of its current direction.

While many concentrate on stock chart patterns, the value of peering into the flow of volume into and out of a stock should not be underestimated. Some legendary traders such as Richard Wyckoff made incredible fortunes concentrating on trading volume.

One of the things that makes volume so interesting and complex is the fact that interpreting it can be somewhat subjective. So today we'll stay with the undisputed. On the most basic level, volume represents the commitment and / or interest traders have in a particular stock. Interest is shown when volume increases. Either more traders are buying / selling or few traders are buying / selling larger amounts. Commitment is also shown when volume increases. In the same way when a gambler has a good poker hand, he may bet more, traders who believe they see good trade are willing to invest more in the trade. This larger investment in the trade is their commitment to the trade. This means the opposite it true too. If volume decreases, then less interest and commitment are observed.

The graph of IBM below has two windows. The upper window indicates the price and the lower window is a histogram of the trading volume for the price. The volume bars are green when the associated price bar above it closed higher than the previous days, and volume bars are red when the associated price bar above it closed less than the previous days. Not all volume histograms are color coded like this, this just happens to be my preference.

In the example below, since we start with a stock trending down, we will start by comparing one downward swing to the next. Notice the downtrends in sections A and B. While the price dropped more in section B compared to A, the trading volume was less, as indicated by our blue trend lines in the volume window. This is typical of a weakening trend, which means it is probably close to ending and becoming a trading range or reversing to a trend in the opposite direction.

Next we compare sections B and C. This time the downward swing in section C doesn't even make it as far as section B did. We could say this was expected or a probable statistic since the volume for section B was less than section A. This time, not only does section C show less trading volume than B, but the trading volume displays a diminishing pattern. This indicates an ever weaker move than B and also means the previous trend is now most likely dead in the water. An attempt to ride this trend further would be extremely risky. So volume would indicate that we now look for an entry in a trading range or a trend in the opposing direction.

Since we have determined that the downward trend is probably non-existent at this point, we will start scrutinizing upward price movements. We could also look for shorting opportunities in a trading range, but I promised to keep it simple for today. Now we compare section D to E. In doing this we note that the trading volume for section D is stronger. This would indicate a continuation in the new upward movement. Armed with this information we could look for a long position in a trading range or trend.

Next we compare sections E and F. More volume accompanies the new upward price movement, again indicating this price action will continue.

Finally, we compare sections F and G. This time the trading volume doesn't just get weaker on the first comparison, but it also shows a diminishing pattern again, notifying us to take extreme caution in following this trend any further and more importantly to be on the lookout for a turn in events. As can next be seen this happens.

Price and Volume Chart of IBM

So there you have it! Volume basics. We have gone full circle, from one trend to the other and back again. A few comments on the above are appropriate at this point. It is much easier to look at peaks in a chart after they have occurred, but with some practice you should be able to spot them before they are more than a few days old.

There are also few exceptions to this basic concept of volume and we'll cover those in a future trading tip. Notice too, we did not talk about entry points here. This is because depending on your objective, the risk level you are comfortable with, whether you wish to trade long, short or both, there could have been several entry points.

A good homework assignment to be able to fully absorb and incorporate the above in your trading would be to pick a chart and page forward in time one price bar at a time using the concept above and try to pick the direction of the stock. Don't bother with picking an entry position, just concentrate on the direction of the price.

KNOWLEDGE IS POWER

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