What Trading Volume is Telling Investors About the Stock Market

Wall Street veterans often say, "Only price pays," but paying attention to trading volume is equally important for investors. Volume, which refers to the level of trading activity, can offer valuable insights into the strength of a stock or the overall market. Unusual shifts in volume frequently signal potential changes in price direction, making it an essential factor for investors to monitor.

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To better understand the role of volume, let’s first define what it is, what typical market volume looks like, and where it originates. In a stock transaction, when a trader sells 100 shares of XYZ stock to a buyer, the transaction contributes 100 shares to the overall volume, not 200. Volume reflects the number of shares traded in a given period. On the New York Stock Exchange, average daily volume over the 50 trading sessions ending on October 3 stood at 3.81 billion shares. On the Nasdaq, the average daily volume during the same period was 5.52 billion shares.

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Institutional investors, including mutual funds and state pension plans, drive the majority of market volume on any given day. Therefore, when volume spikes significantly, it often means that large investors are increasing their buying activity or selling off their holdings. Typically, when a stock rises in heavy, above-average volume, it indicates high demand, and the likelihood of future price increases. Conversely, when a stock falls in high volume, it suggests that selling pressure is likely to persist. The key to volume analysis is to assess it in combination with price movements.

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Market Volume and Trends

Volume analysis is not only crucial for individual stocks but also for assessing broader market trends. It can help investors identify when the market has hit a top or bottom. For instance, when the S&P 500 or Nasdaq experiences several days of declines, and those drops occur with higher volume than the previous days, it could signal that institutional investors are exiting the market. This is often referred to as a "distribution day" in Wall Street terminology, indicating a shift toward selling. Multiple distribution days may suggest that the broader market is weakening, prompting investors to consider reducing their exposure.

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On the other hand, volume can also help identify market bottoms. According to research from Investor’s Business Daily dating back to 1900, every significant market bottom has been accompanied by what’s known as a "follow-through day." After a market correction or bear market, a follow-through day occurs when at least one major index rises 1% to 2% or more, generally within four days of the market low. The gains should come with higher volume than the prior trading day, signaling a potential bullish trend.

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One of the most notable examples of a follow-through day occurred during the aftermath of the 2008 financial crisis. On March 18, 2009, just seven days after the bear market hit its lowest point, the S&P 500 surged 2.1%, with trading volume spiking by 3 billion shares. This marked the beginning of the second-longest bull market in U.S. history. More recently, on August 13, 2023, a follow-through day was observed in both the Nasdaq and S&P 500, indicating a potential market bottom. However, over the past five weeks, the Nasdaq has experienced about half a dozen distribution days, which could be a bearish sign, although it is not yet conclusive.

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Volume and Individual Stock Performance

Volume analysis is equally important when evaluating individual stock performance. If a stock continues to reach new highs but its volume is declining, it may indicate weakening demand, which can be a bearish signal. A great example of how volume impacts stock analysis can be seen in the performance of consumer appliance maker SharkNinja.

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In mid-February, SharkNinja reached new highs for the first time in seven weeks. This upward movement was accompanied by higher volume, signaling strong investor interest. During the week of February 12, more than 8 million shares were traded, compared to an average of just 3.4 million shares in the previous eight weeks. This surge in volume indicated that institutional investors were pouring into the stock. SharkNinja continued its upward trajectory, gaining 60% by the week of June 17. This impressive run was marked by several weeks of above-average trading volume, reinforcing the idea that high volume can confirm the strength of a stock’s upward movement.

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In summary, volume plays a crucial role in market and stock analysis. It not only helps investors confirm the strength of price movements but also provides early warning signals of potential trend reversals. By paying attention to volume alongside price changes, investors can make more informed decisions about when to buy or sell. Whether analyzing individual stocks or broader market trends, volume should not be overlooked as a powerful indicator of future price direction.

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