Stock market requires traders to conduct technical analysis as it helps predict the price changes in the market, regardless of whether they are into day trading or long-term trading. A reliable metric used in technical analysis is volume. Volume represents the quantity of stocks that are being traded over a specific period.
Since the metric plays a vital role, it is important to understand volume indicators, how to use them, their limitations, and their benefits.
How to Use a Volume Indicator in Trading?
Volume indicators in the stock market are key metrics that help determine the strength of stock trends, their liquidity, and a lot more. Here’s how you can use the volume indicator to your benefit:
What is Volume Trading in the Stock Market?
Being in the stock market, you must have come across the term volume trading. It is a common practice amongst traders who choose to rely on technical analysis before putting their money in.
Volume trading is a trading strategy where traders or investors analyse the volume of stock that is being traded at a given time. By determining the volume of stock being traded, traders can better understand whether the underlying stock is valuable and profitable or not.
Remember that under volume trading the relation between the amount of trading and the volume of trade plays a vital role. Here’s an example of volume trading to further simplify the strategy for you:
At a given time in the stock market, the trading volume of Reliance Industries was 81 lakh shares every day and by 2021 the number dropped down to 78 lakh shares in a month. This shift helps understand the strengths and weaknesses of a particular stock over time. 1
What Do High and Low Average Volume Indicators Do?
Volume traders primarily rely on volume indicators to understand the strengths and weaknesses of a stock. This is done by gauging the high and low average volume indicators. It might sound technical and complicated but all you need to remember is that in most cases:
A high volume in the stock reflects the increased interest of traders or investors to either buy or sell the stock. Whereas low indicators under volume trading indicate a weak trend, lack of liquidity and less interest of traders or investors in the stock.
How are Volume and Price Related?
Now that you have reached here, you might be wondering how exactly are volume and price related in the stock market. A common trend seen in the stock market is that prices often tend to fluctuate when the traded volume is high thus reflecting a strong buying/selling pressure. On the other hand, during low traded volumes, smaller price movements are observed.
However, remember that just like any other stock market trend, the relation between volume and price is not cohesive at all times. For instance, a sudden increase in traded volume on a stock represents strong buying/selling pressure but it might take time for the same to start reflecting in the price levels.
Calculation of the Net Volume Indicator
Here’s the formula that you can use to calculate the net volume indicator:
Volume Indicator = Total number of shares or contracts traded during a specified period.
Interpretation of the Volume Indicator
Interpretation of volume indicators is done by multiple methods. However, to give you an idea, remember that to interpret volume indicators you analyse the patterns created by trading volumes and price changes of the stock or any other security.
This, again, is based on the concept that high trading volumes even though price changes represent a strong market trend and vice versa when the volumes are low.
Using Volumes to Spot Momentum
As the name suggests, spotting mementoes is a strategy used by traders to identify points when there is a positive movement between the stock and price. Now, using volume trading can help identify these spots easily.
If the market for a particular stock shows a price increase even during low trading volumes, this represents that the bullish market is losing momentum and there are high chances of a reversal to occur.
What are Common Volume Indicators?
Let’s move ahead with common average volume indicators that will help you make better decisions using the volume trading strategy:
On Balance Volume (OBV)
On balance volume is a common and simple volume indicator that suggests a correlation between price and volume. Traders relying on this type of volume indicator believe that when the OBV line is rising or moving upwards, it represents a bullish trend and vice versa if the line moves downward.
Chaikin Money Flow
Chaikin Money Flow gets its name from a famous American trader Marc Chaikin who invented this volume indicator. According to him, CMF can be used as a reliable indicator to identify whether the market is being dominated by buying or selling pressure.
Here’s how:
If the closing price of a stock is closer to its highest, it represents buying pressure and if the closing price is closer to the lowest it represents selling pressure.
Klinger Oscillator
This volume indicator is used to predict a reversal in trends. Traders compare the price and volume and convert the result through an oscillator to understand trend reversals.
Advantages of the Volume Indicator
Let’s understand the advantages of volume indicators in the stock market:
Volume indicators are extremely beneficial as they help get insight into the market trends that traders rely on to determine the strengths and weaknesses in the market. Additionally, volume indicators can also be used to identify trend reversal or continuation.
Traders rely on volume indicators to make an informed decision about their money. Through a careful analysis of volume and price movements in the market, traders are better skilled in gauging the market participation levels. In addition, traders can also easily understand the impact of buying or selling pressure on the market trends that help them in future as well.
Possibly the most common reason for traders and investors to do volume trading is that it applies to different types of securities and assets in the market including stocks, shares, bonds, funds etc.
Limitations of the Volume Indicator
While there are many advantages of volume indicators, they are not free from the negatives as well. Here are some limitations of volume indicators that you must be aware of:
One of the biggest drawbacks of volume indicators is that they don’t always send accurate/true signals. The dependency on price and volume relation does not apply to the stock market. Additionally, high volumes are not an accurate indicator of a strong trend and there can be cases of an opposite trend.
Another limitation of the volume indicator is that it does not show the underlying reason driving the market trends. It shows market sentiments but the traders have to rely only on the volume analysis to determine market sentiment which can lead to missing out on valuable information on other factors influencing the market.
Volume indicators can fall prey to market manipulation because of their dependency on traded volumes. Powerful traders or investors can use high volumes to create a false impression of a strong market trend.
Volume indicators are reliable in multiple ways but they lag when it comes to predicting future trends. Their approach is largely limited to past activities.
Key Takeaways
Before you leave, let’s take a quick look at what we have discussed so far:
Conclusion
Volume trading is a common strategy in the stock market that can be used for a fundamental understanding of market trends, and entry and exit points to make informed choices. There are different types of volume indicators that can be collectively used for enhanced accuracy.
However, since it has a limited information base it is advised to not rely solely on volume indicators to make trading decisions. It is best to perform comprehensive due diligence.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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