Volume Analysis

Now, you leave the city and are driving on a busy highway. It’s not just about the number of cars on the road but also about how fast they’re moving and how packed the lanes are. The heavier the traffic, the more significant the flow of vehicles. In the stock market, volume is like traffic—it tells you how many shares are being traded at a given time, giving insight into the strength or weakness of a price movement. Understanding volume analysis is crucial because it helps confirm trends and signals whether a market move is likely to continue or reverse.

In this chapter, we’ll break down the concept of volume analysis, explain why it’s important, and show how you can use it to make better trading decisions.

What is the Volume in the Stock Market?

In simple terms, volume refers to the number of shares or contracts traded during a specific period, typically measured in a day. It represents the level of activity in the stock, revealing how much interest there is in buying or selling.

Just like on a highway, where more cars indicate heavier traffic, higher volume in the market means there’s more interest in that stock. Traders use volume to confirm the strength of a price movement—whether the price is rising or falling. Volume acts as a supporting indicator that gives depth to price movements.

But why does volume matter so much? Let’s explore that next.

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Why is Volume Important?

Volume plays a critical role in confirming the validity of a trend. When stock prices rise or fall, it’s essential to know whether the movement is supported by strong trading activity. Higher volume suggests that many traders are buying or selling, which strengthens the price movement, while low volume might indicate that the movement lacks conviction and could be temporary.

Here’s why volume matters:

• Rising Price + High Volume: Indicates a strong uptrend. The price increase is supported by significant buying interest.
• Rising Price + Low Volume: This could signal a weak or temporary rise. Without strong volume, the price may soon reverse.
• Falling Price + High Volume: Suggests a strong downtrend. Sellers are dominating, and the price may continue to fall.
• Falling Price + Low Volume: Implies a weak or temporary decline. The price may stabilise or reverse if buyers re-enter the market.

Volume helps you differentiate between strong trends and false signals, just as heavy traffic helps you understand whether the flow of vehicles on the highway is normal or if there’s an obstruction ahead.

Volume as a Confirmation Tool

In Technical Analysis (TA), volume is often used as a tool to confirm price trends and patterns. Let’s connect it to what we learned about support and resistance in the previous chapter. For example, when a stock price approaches a resistance level, traders look at the volume to gauge whether the price will break through the resistance or bounce back.

• If the price breaks through a resistance level with high volume, it confirms that the breakout is genuine, and the stock is likely to continue rising.
• If the price approaches a support level with a high volume but fails to break it, it suggests that the support is strong, and the price will likely bounce back up.

In both cases, volume helps confirm whether the price will continue moving in the same direction or reverse.

How to Analyse Volume?

Let’s take a look at a few common techniques traders use to analyse volume and what it tells them about the market.

1. Volume Spikes

A volume spike is a sudden, sharp increase in the volume of shares traded. This typically happens when there’s significant news or a major event that triggers a rush of buying or selling. Volume spikes often signal the beginning of a new trend or the end of an old one.

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For example, if Tata Motors announces a major partnership, the volume may spike as traders rush to buy the stock, pushing the price higher. Conversely, if a company releases poor earnings results, a volume spike could occur as traders sell off their shares.

2. Volume and Price Divergence

Sometimes, price and volume move in opposite directions, which is called divergence. For example, if the price of a stock is rising but volume is decreasing, it could indicate that the price movement is losing strength, and a reversal may be imminent. This divergence is a signal that traders should be cautious about continuing to buy.

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3. Average Volume

Many traders look at a stock’s average volume to get a sense of normal activity. If a stock suddenly trades at volumes much higher than its average, it signals that something significant is happening, either in terms of price breakout or a reversal.

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4. Volume Indicators

There are specific volume indicators that help traders analyse market volume:

• On-Balance Volume (OBV): OBV measures the cumulative buying and selling pressure by adding volume on up days and subtracting volume on down days. It helps traders see whether the broader market is buying or selling during price movements.

• Volume Weighted Average Price (VWAP): VWAP calculates the average price of a stock over a specific period, weighted by volume. Traders often use VWAP as a benchmark to see whether the current price is fair compared to the day’s trading activity.

Image Courtesy: Tradingview

Example: Volume Analysis with Tata Motors

Let’s return to our Tata Motors example. Suppose Tata Motors’ stock price has been rising steadily for the past few weeks, but you notice that the volume has been decreasing. This could be a sign that the uptrend is losing strength, and a reversal may be around the corner. You might decide to hold off on buying more shares or even sell your current holdings to lock in profits.

On the other hand, if you observe a volume spike as Tata Motors breaks through a resistance level, it confirms that the breakout is genuine, and you may decide to buy more shares, expecting the price to continue rising.

Volume gives you a clearer picture of market strength, helping you make more informed decisions.

Volume and Trend Reversals

Volume analysis can also help traders spot trend reversals. For instance, if a stock is in a strong uptrend but suddenly experiences a volume spike along with a sharp drop in price, it could signal that the uptrend is over and a downtrend is beginning. Similarly, if a stock is in a downtrend and experiences a volume spike with a sharp rise in price, it could indicate the start of an uptrend.

Volume is especially useful in confirming breakouts and breakdowns. A breakout occurs when the stock price moves above a resistance level, and a breakdown happens when the price falls below a support level. In both cases, if the move is accompanied by high volume, it’s more likely to be a valid breakout or breakdown, signalling the start of a new trend.

Why Volume Matters in Trading?

Volume plays a vital role in helping traders understand the strength of a price movement. While price action alone can tell you where the stock is heading, volume adds another layer of insight, confirming whether the move is sustainable or likely to reverse. Just as understanding traffic flow helps you navigate your way through a city, volume analysis helps you navigate the stock market with confidence.

Conclusion

Volume analysis is a key aspect of Technical Analysis, helping traders confirm trends, spot reversals and gauge market strength. By paying attention to volume spikes, divergence, and volume indicators like OBV and VWAP, traders can make smarter and more informed trading decisions.

Till this article, we have learned all the basic aspects of TA. Now, it's time to move to understanding chart patterns.