The Importance of Trading Volume

The Importance of Trading Volume

Trading volume is the total number of shares traded in a given period of time. It can affect how easily you are able to buy and sell stock. This guide will explore what trading volumes mean for you.
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Beginner
3 min read
Written by: Harry Atkins
March 15, 2020
Updated: January 12, 2021

When investors buy and sell stocks, they typically focus on the price of those stocks. While price is obviously important, there’s another important factor that must be considered when evaluating the strength of an individual stock, or the broad market: trading volume.

I. What Is Trading Volume?

Trading volume refers to the number of shares traded in a stock or the broad market in a given day, week, or larger unit of time. Every day, computerized systems track the number of shares traded in every stock, as well as the number of shares traded on every stock exchange in the world. You’ll usually see volume depicted as vertical bars underneath a price chart. 

II. Why Is Trading Volume Important for Stocks?

By combining both price and volume fluctuations, you gain a better understanding of the stock’s trend direction. A stock that goes up or down to price only tells half the story; volume tells the other half. 

Let’s say that a specific stock trades an average of 1 million shares a day. If that stock jumps 5%, and volume doubles to 2 million shares that day, that’s a sign that institutional investors such as mutual funds are likely buying shares, indicating strong support. Conversely, if a stock falls 5% as volume doubles to 2 million shares, that’s a sign that institutional investors are likely selling shares, a sign of weakness.

The same principles apply on lighter-than-normal volume, just in the opposite direction. Say a stock surges 5% in price on a given day, but trades only 500,000 shares (half its average daily volume) that day, that shows there’s not much conviction behind that price gain, leaving the stock vulnerable to a sharp drop. Likewise if a stock falls 5% in much lighter than normal volume, that’s not necessarily a bad sign, and could instead just be a momentary pullback on the way to future gains.

III. Why Is Trading Volume Important for Market Indexes?

For the same reason as it’s important for individual stocks. When the S&P 500 or other major market indexes rise or fall, you need to monitor whether volume surges to above-average levels or drops to below-average levels. Combining price and volume movement is how you’ll be able to tell what direction the market is likely to move in going forward.

Timing also matters a lot. For instance, let’s say the market goes into a correction. After a while, the major indexes level off. Then one day, the S&P 500 surges 3% in huge volume. That could signal the start of a new uptrend, and possibly a new bull market. On the other hand, several big market sell-offs in a short period of time, accompanied by heavier-than-average volume, could signal the start of a correction, or even a potential bear market.

Moving on…

You now have a better understanding of the importance of trading volume for individual stocks as well as the broader market indexes. Congratulations! Check out our next lesson on market follow-through days by clicking on the link below. If you don’t feel ready to take that next step, check out our wide array of educational articles on this site.

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