While price measures the amount of decline or increase in a stock’s price, volume can be used to measure the power behind it. Higher volume on advancing days versus lower volume on declining days can be a “tell” as large institutions accumulate stock. Since most of the heavy lifting of stock accumulation and distribution is done by large institutions who must buy and sell millions of shares to affect their performance, volume is a credible way to measure the power behind price moves.
If the individual trader or investor was like a vehicle on the road it would be best to jump in and ride shotgun with the biggest most powerful semi’s on the road, rather than take the wheel of a Volkswagen beetle and drive against this traffic.
Volume can validate the trend. If up days are created with more volume than down days it can speak well for the uptrend. Conversely, if volume becomes heavier on down days it can be a sign that a rally is running out of gas. Also as an advanced concept, stocks that continue to drift up on low volume after a higher volume run up should be viewed suspiciously for an impending pullback or sell off; as this may be the “dumb money vrs smart money” buying in after they have seen a power move and feel more confident about it. Perhaps they saw it on a magazine cover or in the news.
Volume concepts hold true in larger and smaller time frames. William O’Neil, founder of Investors Business Daily, says in his book How to Make Money in Stocks, “A valuable clue to the chart reader is the occurrence of big daily and weekly volume spikes… Volume is your best measure of supply and demand and institutional sponsorship.” Who O’Neil is referring to by institutional sponsorship is the big money funds.
Volume can be used to the traders advantage on intraday and swing trades that are more short term as well. If a trade is being watched for a break out from a sideways base for example, that break out has much more validation if it happens on big volume. In fact, many traders have it in their trading plan that they will exit a breakout trade if bigger volume does not accompany such a move. Observing volume throughout a day can give a trader a sense of when accumulation and distribution was taking place.
There always seems to be an opposite corollary to stock market concepts and this is not lost on using volume. There are occasional strong multiple bar moves in one direction (up and down), that end with exceptionally high volume. Such a move is considered an exhaustion or climactic move and it usually empties the room of all the bulls (in the case of an upward climactic move), or bears ( for the reverse). After such a move there is only the opposite party left present in the room and they will usually have their way with the stock then for a while as it reverses.
So one might ask, how is this useful?
Well, first if you own a stock that has gone climactic you could be well served to sell some or all of it. Unless you did not get in near the beginning of the move, you will have made significant profits on most of these by virtue of the run up (or down in the case of a short). Conversely, if you don’t own it and you notice this price and volume action you might think of getting in for the reversal. (This idea usually scares the heck out of most unknowledgeable traders and investors because if they see a parabolic move up in a stock and they intuitively want to buy it rather than short it, often to their disappointment later.) This is an advanced strategy that should not be attempted without a trading plan for it and paper trading it first. Parabolic and climactic moves can have huge profit potential but can also move against you very quickly. A tested trading plan with targets and stops are designed to save the trader from quick large losses.
So another analogy. If you were attending an auction this past weekend and observed large groups of people milling around getting ready to bid on an item just announced, and when bidding starts the whole thing snowballed into a feeding frenzy of higher bids, you would be observing the equivalent to high volume in the stock market. Should bids continue and reach a feverish pitch with bidders rapidly shouting higher and higher prices back and forth it would the the equivalent of a climactic move. This is contrasted by when only a few people bid in a more reserved controlled fashion on the next item that comes up for bid. It is easy to imagine which auction might move price more.
Think of volume as the force and credibility behind a move in price.
Trade with a plan.