Essential Strategies for Trading Volume

The number of shares bought and sold each day in any given financial instrument is known as volume. It’s one of the most accurate ways of gauging money flow. Money flow is used by traders to determine the overall supply and demand characteristics of a financial instrument in an attempt to predict its future direction.

High volume suggests that there’s a heightened interest in the name and it’s often used as a signal of strong upward momentum if it’s combined with a move higher in share price. Keeping an eye on volume will ensure that you’re on the right side of the trade. Several indicators use volume as their primary input and will give you a practical view of how to incorporate volume into your trading strategy.

Key Takeaways

• Active traders use volume as a key indicator to gauge money flow.
• Volume is the number of shares bought and sold each day in any given financial instrument.
• The on-balance volume indicator (OBV) can be used to find stocks that have been experiencing sharp increases in volume without a significant change to stock price.
• Levels with extreme volume can help identify areas where the smart money has decided to actively pursue a position.

A Closer Look at Volume

Take a look at the chart of Delta Air Lines, Inc. (DAL) that’s shown below. You’ll see a huge spike in volume on Sept. 10, 2013 thanks to an announcement that the company would join the S&P 500 stock market index. The strong move higher in the stock price combined with a spike in volume suggested that there was renewed interest in the stock and marked the beginning of a strong move higher.

It’s generally best to align a strong surge in volume with a strong shift in the company’s fundamentals. The addition to the S&P 500 suggested that large index funds and mutual funds would be adding positions in the case of Delta. This would add a layer of underlying demand that would push prices higher. Screens for spikes in volume would have brought this stock to the attention of active traders.

On-Balance Volume

The on-balance volume indicator is commonly referred to as OBV. It’s used to find stocks that have been experiencing sharp increases in volume without a significant change to stock price.

The OBV indicator can prove extremely useful for not pushing the price higher. It’s calculated by adding volume to the previous OBV value when the most recent closing price is greater than the previous closing price. The volume is subtracted from the previous OBV value if the closing price is lower than the previous close.

Important

One of the goals when institutional investors start buying shares is to refrain from pushing the price higher so they can keep their average entry price as low as possible.

You can see from this chart of Microsoft Corporation (MSFT) that the price trended sideways between $34.80 and $37.00 in late 2013 and early 2014. Notice how the OBV indicator was trending sharply higher during this period.

The increasing OBV suggests that traders were becoming bullish on the stock and a stock screen for rising OBV values would have allowed active traders to get in early before the rise to $41.11.

Volume by Price

Another common strategy that involves volume is to use the volume-by-price indicator. Volume is plotted at the bottom of a chart in most cases. It’s plotted on the vertical axis in the case of volume by price so a trader can get an idea of the volume traded at various price points.

Levels with extreme volume can be used to identify areas where the smart money has decided to actively pursue a position. Strong volume moves at key price points are often used by active traders to identify key areas of support and resistance. They can generate strategic buying/selling signals when combined with other indicators.

This chart of AmerisourceBergen Corporation (ABC) shows that most trading during 2014 occurred between $71.50 and $73 as identified by the volume by price indicator: the blue bar used to illustrate the key trading range. Traders would expect the stock to find support near $73 in the event of a broad market sell-off. Notice that there was little volume between $74 and $76 because of the gap. Traders would expect little support from buyers between these areas in the event of a pullback.

What Is a Pullback in Trading?

A pullback is an indication that a market trend has slowed or even stalled entirely due to a variety of possible reasons. This isn’t always a thumbs-up sign for traders. It might be forecasting a reversal.

What Is an Institutional Investor?

An institutional investor manages portfolios and trades for other investors, typically for individuals. It’s an organization as the name suggests. It might be a mutual or hedge fund, a pension fund, or even a credit union or a bank.

What Are Some Other Trading Signals?

Some other frequently used trading signals include the relative strength index (RSI), the moving average convergence divergence (MACD), Bollinger Bands, and stochastic oscillators.

The Bottom Line

Volume is one of the key indicators used by active traders to gauge money flow. Indicators that are derived from using volume such as on-balance volume and volume by price can be used to create lucrative trading strategies.

It’s often smart to combine trading signals generated by changes in volume with a shift in a company’s fundamentals. Simple stock screens that identify securities with sharp changes in volume are great candidates for traders who are looking to create a watch list.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.