Why investors should consider trading volume

This means that the share price movement may be dictated by a few operators, not by the consensus view of the market. Since technical analysis tools are designed to measure the mass psychology of participants, it can work only if the stock has a large number of investors.

Before trading in any stock,  investors  need to make sure that the average trading volume is sufficiently high. This is because unlike the stock prices, the volume can move up and down drastically within a short time period.

So, while a stock may generate only a few thousand shares on a particular day, the trading can be in lakhs on some other day. By using the average, say 10 day average, investors can get a fair idea about the liquidity of the counter.

Theories: The first theory is that volume typically follows a trend.

Since a bull phase is usually triggered by the increased interest in a counter, it is natural that the volume also jumps up during this time. Similarly, it is common for the volume to come down during a bear phase. However, if the volume continues to fall when the price is constantly moving up, it should act as a warning for the investors.

This shows that the bull phase doesn't have enough depth and the probability of a turnaround in such a phase is high. The best example of this can be seen in the DLF chart during the 2007-9 period, when the volume continued to move down throughout the bull phase and started picking up only in the bear phase.

Next is the theory of accumulation (bullish sign) and distribution (bearish sign). Accumulation and distribution are usually measured at much closer intervals, say, on a daily basis. If a share price moves up on a given day with increasing volume, it is a sign that the buyers are able to absorb the increased selling pressure and, therefore, it is treated as accumulation by strong hands. Similarly, if the price comes down on a particular day with increased volume, it indicates that the buyers could not absorb the increased selling pressure and is treated as distribution by strong hands.

Confirmation tool:  Investors should note that volume is only a confirmation signal, not a solo indicator. This means that the original signal should be reflected in the price chart, and the volume can be used to confirm it. Note that the rules are slightly different for buy and sell signals. For a buy signal, a jump in volume is a must. As is evident from the HUL chart given below, the stock's breakout to a new, all-time high during October 2011 was supported by a heavy volume and, therefore, was a clear buy signal.

However, investors can act on a sell signal even without a volume confirmation, that is, an increase in volume. This is because share prices can come down either due to lack of buying interest at higher levels (resulting in reduced volume) or by heavy selling pressure (resulting in increased volume).

The first situation is treated as bearish and traders use it to square off their existing long positions. The second situation is very bearish and traders usually wait for it to take new short positions. The four situations can be summarised as follows: price going up with increased volume (bullish), price going up with reduced volume (not so bullish), price going down with reduced volume (bearish), price going down with increased volume (very bearish).

Volume or value?  While volume is most commonly used, technical analysts need to understand the importance of the total traded value, that is, volume multiplied by share price, as well. This is because value automatically takes care of events such as a split or bonus in the counter. Since such events may take place over a period of time, replacing volume with value becomes more important when one sees the long-term  charts.