Basic economics dictates the premise of supply and demand and their ramifications on price. This theory holds that when demand exceeds supply price will appreciate, and when supply overshadows demand asset prices will fall. Indeed this holds true when markets rise and fall as it reflects the urgency of one side of the market to trade as opposed to the other. Yet every trade has a counter party; a buyer and a seller. On the face of it, this clearly indicates that demand and supply are equal, yet that price is rarely static reports to a further dynamic lending itself to momentum, inertia and urgency.
Markets are able to fluctuate somewhat freely on light volume as prices are pushed around by one or two big orders on a quiet trading day. Yet when trading volumes show a significant increase from the norm, this indicates substantial market interest. Here, buyers and sellers of varying points of view are increasingly interested in divesting each other of their respective positions.
While 80% of all trading activity has been found to be stop loss oriented, this alarming fact points to the variety of motivations that market participants adopt to investment decisions. Some are long term some short term; some are taking profits, some losses. Amid the confusion, one thing can be certain. When trading volume experiences a sharp increase – a dramatic market shift is imminent as the price has motivated substantial participants to become involved in decision making. At the end of a prevailing trend, volume will increase markedly, and so the market confirms this by participation. Rarely would this occur mid-trend as by definition a trend needs urgency of either supply or demand to outweigh one the in order to maintain its course.
Proponents of other indications such as technical analysis’ support and resistance, momentum’s MACD index, and mathematics’ Fibonacci numbers will all seek confirmation with an increase in volume prior to extending a signal. Primarily as the market needs to be supporting or rejecting a certain price, the absence of volume can hardly suggest that is the case. Indeed dwindling volumes are more an indication that the trend has met a natural end and that a retracement is imminent. A retraction in trading volume indicates that momentum is slowing and will find much profit taking entering the market, which will itself perpetuate movement back to true value.
In this sense, volume is rarely an indicator applied in isolation and is keenly attuned to other indicators and in particular, momentum. Still volume must be adjudged with relative comparison as some markets have typical volumes that would astound others. Volume ought never to be ignored as it indicates the bastion of trading activity – participation.
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