4 Revelations from Trading Volume

4 Ways Trading Volume Provides Stock Market Clarity

iPad stock trading chart
man looking at trading chart. Multi-bits

Surprisingly powerful information can be revealed by daily trading volume.  Much like a poker player beating her opponents without looking at her cards, some of the following concepts can help investors reap profits without even looking at the rest of the stock chart or the company's fundamentals.

Trading volume refers to how many shares of a stock trade hands.   Every trade requires a buyer and a seller - one share sold means that one share was bought.

In this simple example, trading volume would equal one (for the single share trading hands).  Trading volume is tracked on a daily basis, and typically presented at the bottom section of the stock's chart.  

Always think of trading volume in terms of the percentage of total shares.  If one million shares of Apple trade hands, that is not a significant percentage out of the total 5.8 billion.  However, if one million shares of a penny stock with only ten million total shares are traded, that is a meaningful amount.

The following four concepts in trading volume are especially relevant and effective with penny stocks.

1. Shareholder Turnover:

Shareholder turnover is very significant.  Investors who recently bought are more likely to hold their shares, rather than sell any time soon.  They saw something they liked in the company, and purchased in the hopes that the stock price would rise.

Turnover is not an exact science, but it is usually very helpful.

 This concept is also most reliable when:

  • the stock's price is relatively flat (trading sideways)
  • there are no major events moving the shares
  • sellers are about the same in numbers as buyers (resulting in the flat share price)

Uncovering shareholder turnover is simple.  You can see the total number of shares outstanding from just about any online investment portal, like Yahoo Finance, or MarketWatch.

 Now, compare that to the recent trading volume.  

If 20% of shares have traded over the last week, and the stock's price remained relatively range-bound, you can make a few assumptions about the makeup of the shareholder base:

  • 20% are newer, and less likely to sell
  • Many of those who wanted to sell now have, reducing the 'supply' of shares

Turnover eventually hits a tipping point (assuming no other factors derail the process), where 30% or more of outstanding shares have new owners, within the most recent two or three months.

The mix of shareholders is leaning away from those wanting to sell, and towards those looking to hold.  Future demand for the stock will overwhelm supply.  When shareholder turnover hits a tipping point, any new buying interest eventually results in the shares driving higher.  

2. Sustainability:

Investors often wonder if a price collapse might be a buying opportunity.  They also ask for clarity of what to do when shares when their penny stock spikes suddenly and significantly... when should they sell?  Trading volume will provide all the answers.

The faster something rises, the faster it falls.  A sudden 100% increase in the price of a penny stock, on trading volume that is many times greater than the daily average, typically fades away over the coming days.

 The shares usually come back towards where they traded in the first place.

Unlike rapid price spikes, the slower and more consistent the increase, the more likely the gains will be permanent.  Ideally, a stock rises by two or three percent per day, with trading volume being only slightly higher every day.  This example would represent an increase in the price of the penny stock that will remain intact.

Also, when a penny stock's price spikes with a somewhat regular amount of trading volume (for example, twice the twice typical amount or less), those gains are more often sustained.  Dramatic price moves (whether higher or lower) which are not driven by overwhelming trading volume will typically remain intact   Those which are driven by huge spikes in trading volume are most likely to fade away or reverse.

3. Breadth / Significance:

The breadth refers to the various individuals who many be trading the shares, and will tell you a great deal.  It matters whether shares were all traded by one person, or 3,312.  Of significance, who is doing the trading should also matter, such as the Executives (CEO, Managers), institutional investors (mutual funds, hedge fund managers), or just regular people like us.

Maybe some rich guy wants to buy his granddaughter a pony, so he dumps a million dollars worth of a tiny penny stock.  The trading volume might suddenly spike, while the share price collapses, and shareholders scramble and panic.  This example does not reflect negatively on the company's prospects, and actually represents an excellent buying opportunity.

In some cases, perhaps all the employees and managers of a company start buying, perhaps because they know the business is doing very well and growing rapidly.  Recognizing this situation may assist in your trading decisions.

Either way, always watch the breadth of trades.  While difficult, and in some cases partially not possible, attempt to learn how many individuals are involved in the trades which are generating the trading volume.  Look into who is buying and selling.  

All Insider transactions are legally required to be publicly revealed, so you'll find them on most online financial portals.  Your stockbroker often has Level II quote tools which allow you to see some details on various transactions... (see if trades are coming in from many different brokerage houses, which typically means they are from various individuals).

4. Reliability in Technical Analysis:  

Technical Analysis (TA) attempts to reveal the future price direction of a stock, based on previous trading patterns.  For example, when a Support Level is identified on the trading chart, that may mean that the shares are less likely to fall below those price levels.

There is some merit in TA with heavily-traded shares.  However, with penny stocks (which are typically more thinly-traded) only some TA patterns should be considered reliable.  We will have a complete article released here shortly, which describes the few specific TA patterns which work with penny stocks.

The greater the trading volume, the higher probability that an established TA pattern can be trusted by investors, and profitably acted upon.  If a TA set-up seems to be establishing itself on the trading chart, take a look to the trading volume.  A consolidation pattern, resistance level, price dip, or otherwise (again, we'll get into all of these in an upcoming article) may look perfect, but can only be acted upon if it formed with significant trading volume, such as 40% of total outstanding shares being traded, rather than only one of two percent.

These four revelations from trading volume are proven, and can be very helpful, especially with penny stocks.  You will profit much more by knowing when to sell, load up on more shares, panic, or wait.  Understanding trading volume will reveal all of this to investors.