When an equity makes a big move, volume is one of the first factors traders should check before making a trade.
All too often, a stock will be trading in a trend and suddenly, the equity breaks the trend. Traders catching the move may buy or sell shares. However, after placing the trade, the stock jumps right back into the trend and traders are left with a loss. Low volume price swings are often the perpetrator of this activity.
Applying the simple concept of supply and demand, a low volume move often suggests a short-term surplus of one of the two at the price the equity was trading at. For example, when a stock jumps higher on low volume, it may mean that there are temporarily few sellers at the security’s normal equilibrium price.
If no fundamental information was released, there is no substantial change in cash flows or risk of those cashflows, meaning share prices should be essentially unchanged. This is the reason markets correct these moves. As traders realize this inefficiency, they correct the move and take profits as the stock returns the channel it had been trading in.
In contrast, if volume is high, it is often the result of fundamental data.
There are several ways traders can analyze volume. Most simply, traders can compare volume of the current day (or other appropriate time period) to the ten and fifty day averages. Keeping in mind that most volume comes at the beginning and end of the regular hours session, traders can quickly check how far through the trading session they are and compare that to the full day.
There are also several indicators to track volume; on balance volume, for example, is one of many. OBV is a very simple indicator that adds one for each uptick and subtracts one for each down tick. One way that traders use the indicator is watching how it changes when compared to price.
A rising OBV indicates that volume on up days is greater than volume on down days, commenting on supply and demand of the issue at the current price. The general rule of thumb is that a rising OBV coupled with a flat stock price indicates that shares are likely to rise. Other volume indicators worth looking into include: Money Flow Index, Force Index, Ease of Movement and Chaikin Money Flow.
However, traders should note that there are situations where volume is not completely telling. For example, if a mutual fund has a sudden inflow or outflow of capital it may make large purchases or liquidations that can send a wrong signal to the market by temporarily effecting supply or demand which is not based on any fundamental changes in the stock.
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