Introduction
Stocks volume is an often ignored metric in a stocks performance. You might say aren’t we only concerned with the price of a stock and its movement? Yes our final concern is price but we want to find indicators of how a price is going to change before it does. Volume is such an indicator. A stock’s trading volume is the amount of stock traded or changed hands during the specified period of time. Generally we refer to daily or weekly trading volume. Now the price of a stock is just like the price of anything else we pay money for in that its value is determined by supply and demand. This is how volume gives us indicators of coming price changes, it tells us the levels of supply or demand for a particular stock. Read on and I will explain exactly how that happens
Stocks and Supply and Demand
Highly successful investor William J. O’Neil noted that “stocks never go up in price by accident – their must be a large buying demand. When demand for something increases and supply remains constant the price increases. Conversely when the supply of something increases and the demand remains constant its price decreases. This is the law of supply and demand and it is a fundamental economic concept. A stock since it is paid for in cash in a free market functions according to this law. When there are more buyers than sellers demand increases and the price eventually increases as well. When there are more sellers than buyers the supply increases and the price eventually decreases. This is just like the housing market. When less are buying houses for whatever reason the cost of houses goes down. What we are going to do is find ways of using the trading volume of a stock to measure its supply and demand levels. Let’s talk about how we can do that.
Evaluating Supply and Demand
The first thing to look for is whether a stock has more buyers or sellers. IN investing terms if a stock has more buyers we say it is being accumulated and if it has more sellers we say is being distributed. To measure whether a stock is being accumulated or distributed we look at the daily trading volume closing price. If the stock closes at a higher price than the previous day on larger volume it’s a signal of accumulation. If it closes at a lower price on higher volume it’s a sign of distribution. With both directions the greater the volume more significant the action is. This is why low volume selling doesn’t necessarily mean you need to sell a because it is being distributed. However if you have multiple days for closing down in price on above average volume you stock may be getting ready to turn or already has.
A rough gauge of accumulation and distribution can be arrived at by looking at a daily stock chart for the stock in question. Count the days where the stock closes up in price on above average trading volume and compare that to the number of days it closes down in price on above average trading volume. This gives you a general indication of whether it is being accumulated or distributed. If you subscribe to a financial paper you may have access to more detailed metrics for accumulation and distribution. Investors Business Daily has an accumulation/distribution rating does a similar count but in much greater detail and it gives A to D scale telling you to what degree a stock is being accumulated or distributed. This can be a big time saver in determining a stocks supply and demand.
Strength of a Breakout
Stock breakouts do not always succeed and instead of blasting to new highs they can’t seem to make it past a point and drop back down. This may happen over the course of one day or it may take multiple days. You can judge the quality of the breakout based on the volume level on the day or days in breaks out. If a stock breaks out on 50% or more above average volume your its likely a breakout that will succeed. Conversely if it’s significantly below average the stock may bounce back after a few days. What is happening is there is a fast increases in demand and a shortage of sellers. Keep in mind that when buying off of a breakout you want to buy when the stock is emerging from a properly formed chart base or area of price consolidation.
Price consolidation
To identify stocks that are getting ready to breakout you want to look for areas of price consolidation. This is a time during which large buyers (institutional buyers) are gradually building their positions in a stock. This takes a few days to a few weeks. During this time there will be multiple days of high volume trading where the stock closes up in price but not with a significant price advance. This is also referred to as tight trading. Once the institutional buyers have a good position they will start making large buys to trigger others to buy the stock on the obvious advance. The increases demand will shoot the price up but the institutional buyers will hold there position thus not adding to the supply. This is not the only way breakouts happen but it is an example of a common one. This brings us to the next question of why do these large institutions have such a sway on the price of a stock?
Institutional Buying
By far the biggest source of accumulation and distribution is large institutions such as mutual funds and pension funds. William J. O’Neil points out how significant the buying power of institutions is. “If a single fund has $ 1 billion in assets and wants just a 2% new position in a stock, they must buy $20 million worth of it. That’s 500,000 shares of a stock selling at $40 per share! Funds are just like elephants jumping into a bathtub. They are simply so big the water rises and splashed all over the place.” This means that you want to be buying stocks which institutions are buying to benefit from the momentum they carry. When they trade their will be massive adjustments to the supply and demand of a stock.
We talked about earlier how when an institution wants a position in a stock it does not do it all at once. It builds up over the course of a few days or weeks to try and buy into it without increasing the price significantly. This gradual buy will show up as accumulation on the stock charts. Even in small amounts institutional buying is hard to hide. For more intermediate trades you want to identify these areas of accumulation so you can buy into stocks before they breakout. However accumulation is also beneficial when holding a stock for a longer period of time. Institutions don’t turnover their portfolios as often as individual investors do. This means that a stock that institutions are buying is more likely to have sustained result and stability than one without it.
One way to spot to accumulation over a longer term is to see what better performing institutions already own or have purchase recently. Institutions are required by the SEC to disclose their purchases. You can view these purchases in the ownership section on financial sites like Google finance. If you read Investors Business Daily or another financial paper you have access to a sponsorship rating which does this research for you. They may also tell you the percentage change in ownership of a stock over the past few quarters. This gives you an indication if more funds are buying in or selling out. William O’Neil says that “if none of the better performing funds has bought a particular stock, I would stay away.”
How to Track Volume
The value of a stock’s or an index’s trading volume is not meaningful unless we compare it to the previous periods to see it’s change over time. The Wall Street Journal and other financial papers list a stocks trading volume for the day. This works but it can be cumbersome to mentally track a stocks trading volume over a period of time. Investors Business Daily’s stock tables have a helpful feature which is listing the stocks daily trading volume as a percentage of its 50 day average volume. Using this you can quickly glance through the stock tables and see which stocks are being accumulated.
Stock tables scan a lot of stocks for erratic changes in volume but they don’t help you track a stocks volume changes or seeing past movements. The best way to do this is by using stock charts. Charts show you price and volume action over time in intervals of days or weeks and make it easier to identify accumulation, distribution and areas of price consolidation. Charts are available at free financial sites like Google and yahoo finance.
Conclusion
That is a good introduction on using trading volume as an stock indicator. To successfully utilize this in your investments I would recommend reading Investors Business Daily(IBD). IBD is an great way to get professional level data and research and not have to spend hours of your time or a significant amount of money to get it. A determined person could probably pay for the cost of an annual subscription in just a few weeks of trading with it.
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