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The Impact of Trading Volume

  • 2000 12 May
The Impact of Trading Volume
Reprinted with permission from World Finance Net IPO Newsletter, written by Alexander Frauenfeld

For investors in the US equity markets, recent trading activity has been a real nightmare. Especially if you are a short-term trader, the last couple of weeks and months should have provided you with a lot of sleepless nights. In looking for explanations for all this volatility, one useful exercise is to examine the trading volume. While it might sound a bit boring, trading volume has a lot to do with the choppy markets of late.

Daily trading volume represents the total number of shares that change hands in the market during the day. Several measures are frequently used to describe volume; these include "heavy" or "active" for trading days of high volume, "light" or "thin" for low volume days, or "moderate" for something in between. Volume is generally used to interpret the strength of the market. It is evidence that buying and selling of stock is or is not happening.

Earlier this year, observers of the markets were astonished by the amount of trading activity on all the major market indices. The Nasdaq surged above 2.5 billion shares traded in a single session, and the NYSE reported a volume of over 1.5 billion shares. Those kinds of numbers had never been experienced before, and definitely not on a consistent basis. Officials at the exchanges even became concerned their trading systems would not be able to handle that kind of activity.

What did all that volume mean? January represented a large inflow of cash due to a very strong 1999. Nasdaq closed out 1999 with an 86% performance, and therefore attracted a great deal of attention. One can assume lots of year end bonuses were poured into Nasdaq issues. And the surging demand for Technology equities pushed valuations through the roof.

Most of those irrational valuations have now returned, painfully, to where they started that dramatic rally. Cash inflows have drastically slowed as the market has stumbled, and in many cases cash has been coming back out. Interest rate jitters have not helped as the Fed threatens to increase rates going forward.

As a result, trading volume over the last 6 weeks has been barely existent. The major exchanges are trading at 50% below the rate seen earlier this year. That translates into the markets being directionless and very choppy. Why? Low trading volume simply means fewer buyers and sellers. With little supply or demand in the marketplace, those few buyers or sellers of a stock will be able to dramatically affect the price of that stock. A couple new buys can push the price up, just as a few sells can push the price down. That increased volatility in price causes other investors to get nervous or excited, and their reactions in turn add to the volatility.

The bottom line is that when volume is heavy (active), investors may interpret changes in the Dow, S&P500, and NASDAQ with confidence, since they represent the judgment of many investors. However, when volume is light, changes in these indices are suspect. They reflect the judgment of only a limited number of investors, and changes in stock prices are not very reliable. Seasoned investors generally ignore changes in a given stock price on days when trading is light.

Therefore, market movements of late have to be taken with a grain of salt. We will be able to anticipate the market's true direction once trading volume picks up again. Unfortunately, until then choppiness will just be a fact of life investors and traders alike.

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