How to read trading volume data to understand stock price direction

Along with stock price action, trading volume can be one of the most significant technical parameters to determine where a stock may be heading. The overall market activity in a security gets reflected in trading volume, which indicates investor interest and how they perceive an asset at a given point of time. It is one of the most closely watched indicators after price action.

Trading volume is considered a solid technical indicator, because it represents the overall market sentiment around a security or the market. Investors frequently use trading volume to confirm the existence, or continuation of a trend or trend reversal. Unlike stock prices, trading volume can also move up and down sharply within a short time. Volume can change drastically from few thousands to lakhs on any particular day. By using the average, for example 10-day average, one can get a fair idea of the available liquidity on the counter.

Trading volume can help an investor in identify momentum in a security and confirm a trend. For example, if trading volume increases in a particular session, prices generally move in the same direction. That’s why, for a security to remain in an uptrend, the volume of the security should ideally increase along with price.

However, while analysing volume one should use certain guidelines in determining strength and weakness of a move. Although the below guidelines are not true in all situations, but they can broadly help make trading decisions:

Besides helping spot a trend, trading volume can also help guide an investor take profit and sell a security just in time. If there is no relationship between the trading volume and the price of a security, this signals weakness in an ongoing trend, which could be precursor to a trend reversal. In uptrends and in a sideways market, the stock price will occasionally run into a resistance level and hold there.

However, when the price breaks above the resistance level, the breakout is generally believed to be more significant if the trading volume is high or above average. A breakout accompanied by low volume suggests lack of enthusiasm for the ensuing move.

Trading volume plays a key role in fundamental analysis too. Because it is very easy to manipulate a stock with low trading volume (called an illiquid counter). Long-term investors, especially institutional investors like mutual funds, usually avoid stocks that don’t have sufficient trading volume.

Trading volume reflects traders’ actions in a security or stock counter; it can be used as a very useful measure of sentiment. As a thumb rule, any price breakout or trend accompanied by above-average volume is considered to have potentially greater significance than regular price movements.

(DK Aggarwal is the CMD of SMC Investment and Advisors)