How To Use Volume Analysis To Make Better Trades

In the stock market, volume is a very important indicator. In fact, every trading platform invariably includes volume.

This is because the volume indicator is one of the easiest ways to observe a stock’s buying and selling activity at the key levels. Whenever volume analysis is used in combination with price action, it increases the probability of picking a winning trade.

What is Volume?

Volume is basically the number of shares of a stock that trade over a specified period. This period can be a day or even 1-minute.

On a stock chart, the color of the volume bar is either green or red. The green bars are shown if the stock price closes higher while the red bars are shown if the stock closes lower for the given period. The figure below shows how the volume is represented in a chart.

The rule of thumb is that ‘the higher the volume, the more active the stock’. This is why day traders usually trade stocks that have high volume. This is necessary for day traders to quickly get in or out of a trade with ease.

The 3 Uses of Volume Analysis

Volume analysis can be used for three main things – to confirm trends, to spot potential price reversals, and to confirm price breakouts. Nevertheless, remember that volume is always a secondary indicator to price. This means volume doesn’t provide trade signals on its own.

Let’s now see how volume can be used in conjunction with price analysis in each of the three scenarios.

#1 Trend Confirmation

  • Volume should increase during moves in the direction of a true trend.
  • Whenever there is a decrease in the volume during a counter-trend move, it implies that the trend is strong and could continue into the foreseeable future.

The figure below shows how volume increased during the up moves for a stock which was in an uptrend.

#2 Price Reversal

  • Decreasing volume during a stalling trend may indicate a potential price reversal.
  • This means that decreasing volume during an uptrend (or downtrend) indicates that a potential reversal may happen soon.

When there is a huge volume spike following an up move and then the price suddenly drops, watch out for the volume on the next price rally. In case the volume on the rally is lower than it was on the volume spike, there is a good chance the price will continue lower.

The figure below shows a price reversal.

#3 Price Breakout Confirmation

Volume can be used for confirming price breakouts, especially near the support and resistance levels of the stock.

  • A breakout above resistance level or a breakdown below support level with a larger than average volume usually indicates that the breakout/ breakdown is possibly legitimate.
  • On the other hand, if there is only low volume, the breakout or breakdown will likely fail.

The figure below shows a legitimate breakout from a major resistance level, thanks to the high volume associated with the move.

To make volume analysis easier, there are a few volume-based indicators as well. Some of them would be discussed in later lessons.

Happy Trading!