Wednesday, March 3, 2010

Trading Volume

What is trading volume and why is it important?

Technical analysts consider only two pieces of information relevant to determine the potential future price behaviour of a security (and therefore, potential trading strategies for it): the stock price itself and its trading volume both analysed over time. As you can see, trading volume is a very important technical tool and whether you base your strategies around fundamental or technical analysis it is imperative that you understand and interpret what it might reveal about a potential stock or any other financial instrument that you might be about to invest in or trade.

First, it's important that we understand in very simple terms what trading volume is. I will base my analysis mainly on stocks but it can also be applied to all other financial instruments. Trading volume is simply the number of shares that were bought and sold during a certain period of time. For example, if we look at a trading day, we can talk about how many shares were bought and sold during the day and that would be the trading volume for that particular day. You could also narrow it down as much as you'd like and get intraday volume readings every minute or 5-minute or 10-minute period, etc. For us as investors and traders (especially if your time horizon is longer than a day) a volume reading that we pay particular attention to is the daily trading volume for a stock.

When you read a typical stock quote, volume is one of the numbers that is normally included, given its importance. For example, let's say we wanted to know how many shares of investment bank Goldman Sachs (ticker: GS) were traded today. We would simply use our broker's interface or our preferred financial data provider and look it up to find it out. In this example, today (March 2nd, 2010) the volume for GS was 11,995,851 shares so almost 12 million shares.

Interestingly you can start to get a sense of the amount of money that is moved around financial markets daily. In this case, only looking at Goldman Sachs today,  12 million shares changed hands and since the stock is trading at around $158 (of course several different prices were involved during the day, from a low of $156.91 to a high of $159.75 per share) roughly around $1.896 billion dollars were used to buy and sell GS stock.

Also, to put everything into context we should note that Goldman Sachs has a float (total number of shares that can be traded in the market) of around 486 million shares, so 12 million is a really small percentage of the total tradeable shares (around 2.46%). A similar analysis can be carried out on any stock that is publicly traded.

Now you might ask yourself, why is volume important to my trading or investing? On its own, trading volume is a good indication of the liquidity of a stock. This means that if many shares are traded daily in the market, then it will be relatively easy for you to buy or to sell stock whenever you need to. Think of the situation with other assets, for example real estate. It is not as easy to buy and sell real estate since the number of buyers and sellers is rather limited and the nature of the asset requires careful examination before buying or selling. This means that maybe when you need to convert some real estate asset into cash quickly you are going to have to take a lower price than you could get in the same market if you didn't have the urgency to sell. With a liquid stock, you can access your broker's interface or call up your broker and you can easily and with relatively little price disruption buy or sell anytime during trading hours and as often as you would like.

Relatively non-liquid stocks can also be traded and you are almost always assured to have a buyer when you want to sell and a seller when you want to buy but because of its lack of liquidity you might experience wild price swings to process your whole order.That is because there is not much competition among buyers (when you want to sell) and sellers (when you want to buy) to give you the best execution price for your order. As a practical number, I try to never trade or invest in companies that trade less than 1 million shares a day. You need to find the number that gives you peace of mind and the confidence that you will have enough liquidity not only when you buy but maybe perhaps more importantly when you sell.

Volume on its own can reveal the liquidity of a stock but when we look at volume patterns, we can get important clues as to the behaviour of its stock price. Normally, people trade in and out of stocks on a daily basis and sometimes these transactions don't indicate changes to fundamentals or a fundamental re-pricing of a stock. Imagine if an institution, let's say a mutual fund needs to sell some of its holdings because of clients' redemptions. This does not alter the prospects for the stock that they are selling and still, because of this sale, the stock price might go down. The important thing here is how to spot real changes to a stock price as opposed to meaningless variations because of situations like the one I described above. This is easier said than done of course and traders devote entire lives to become better at identifying these situations but a good place to start is to look at volume.

In order to know whether a certain trading volume is significant or not, most traders use an average of the trading volume over a certain period. In my case I look at the average trading volume over the last 3 months as a good indicator. If volume on a certain day is higher than average, this means that the move that the price is making is finding a lot of volume support and that more transactions are taking place at this price (especially if its a significant price change).

For example, today March 2nd 2010, Staples Inc (ticker: SPLS) had a price change of -10% ($25.86 to $23.25) and a trading volume of 49.5 million shares. Given that the 3-month average is around 7.6 million shares, you can see that the price move is most likely not a day to day fluctuation but an actual re-pricing of the shares (in this case because of an earnings release).

Technical analysts like to see strong volume support when a stock is moving because this confirms that the stock is moving not because of a lack of sellers or buyers but rather that the new prices are being accepted by more and more market participants (as evidenced by the surging volume).

A contrarian view to the same phenomenon would argue that on a day when volume is several times above normal, the move (either up or down) has run its course . For example, on bad news, with all that volume, this is as low as the shares went and no further, so this can be a good indication that at least for the time being the stock found willing buyers at that low price and can act as a temporary floor to further declines.

As with everything in trading, you will need to develop your own trading strategies and views of the market and market psychology but it is important that you understand all the tools are your disposal. If you are a technical trader, your two main indicators and in fact the only real indicators are price and volume (since all other indicators are derivatives of these two).

Finally it is important to note that for companies with a relatively small float, the trading volume can also offer clues as to potential volatility. If a company trades for example half of its entire float on a single day usually, then it is a very good bet that the price fluctuates wildly because half of all tradeable shares are changing hands on a single day. If your trading style favors volatile stocks then volume offers a good indication as to the potential volatility of that stock.