Why Does Trading Volume Matter?

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Trading volume is the number of a security’s shares traded during a given period of time. Trading volume indicates the overall activity of a stock and its momentum, and it is an important technical indicator used by investors to look at stock trends. Volume gives investors an idea of the price action of a security and whether to buy or sell the security. Increasing trading volume is generally associated with positive price movement, and vice versa.

Low Volume (Illiquid) Stocks

Stocks with low volume are often associated with the following attributes:

Volatility – When a stock has low daily trading volume, the price of the shares tends to be more volatile. Since a company’s market value is based on the most recent price per share, limited shares traded each day can result in the market value seeing large percentage swings intra-day and day-to-day.

Reactivity – Because trades are less frequent and there are usually fewer shareholders invested in low-volume stocks, low-volume stocks are more likely to move on news events.

The net effect of illiquid stocks is generally negative for both investors and issuers:

Investor – For institutional money managers to build a meaningful position, they may have to spend weeks or longer buying a small number of shares at a time until they complete their position. With illiquidity driving volatility, investors need to stay patient to not drive the stock up above a price where they remain a buyer. For sellers, the lack of liquidity makes it harder to get out of a position as they may drive the price too low. For both buyers and sellers, sometimes the only opportunity to trade a position will be a news event that creates more liquidity for a short period of time.

Issuer – For an issuer, low trading volume is undesirable as it may prevent institutional ownership. If trading volume is not very high, the security will tend to be less expensive, since people are not as willing to buy it. Additionally, low volume stocks carry with them a “liquidity premium,” which means that less-liquid stocks should be lower priced. This is because to buy an illiquid stock, investors will demand a higher return to compensate for the risk that they may not be able to easily sell the low-volume stock at a later date.

High Volume (Liquid) Stocks

Stocks with high volume often are associated with the following attributes:

Less Volatility – High volume stocks are less volatile as price changes are more fluid with the high volume of transactions processed. Stocks that change hands rapidly have fewer dramatic price changes.  When so many people are buying and selling, and there are literally thousands of orders waiting to be filled at any minute, the spread between the bid and ask will be smaller, allowing for the stock price to move in smaller increments.

Less Reactive – High volume stocks will not move as quickly as small volume stocks on news events. Trading tends to be more efficient, since there are more investors in the market for the stock at any one time.

The net effect of liquid stocks can be positive or negative, depending on whether you are an investor or an issuer:

Investor – The low volatility and reactivity of high-volume stocks can create a competitive environment for investors, leading to higher prices.

Issuer – For an issuer, high trading volume is desirable.  The high trading volume indicates that there are many buyers competing for the asset, and the laws of supply and demand will cause price appreciation.

Trading volume is just one piece of the full story behind a company and its stock.  While trading volume can be an important indicator and component of a company’s financial profile and strategy, it is helpful to understand the meaning of trading volume, how it can be interpreted and how it should be considered as one looks at the entire picture of a company and its investment profile. For more information on trading volume and what it means for retail investors, contact us.

Debbie Kaster, Managing Director

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