Want a Jet-Fueled Trading Idea? Consider Incorporating Volume

Look to the sky near twilight from any number of towns that dot the length of the California coast and there’s a good chance you’ll see a long, glowing contrail—the sign that a rocket has recently been launched from Vandenberg Air Force Base. These rockets, designed to place communications satellites into orbit, have mythical names like Pegasus, Atlas, Taurus, and Minotaur, and the speed and heights to which they travel are determined by the amount of fuel they carry.

In the market, the fuel that drives stocks is volume, and just like the rockets from Vandenberg, understanding how much fuel is behind a move can help you determine how high—or low—price may go, and how long that trend might last.

Octane Ratings

Volume is composed of the number of stocks or contracts traded. Although there’s always a buyer and a seller on each side of a trade, it’s the transaction price, relative to that of the previous trade, that determines whether it’s considered “up” or “down” volume. 

This, in keeping with the rocket theme, is the “contrail” that volume leaves behind. When trading or investing in stocks from a technical perspective, this volume contrail is what might confirm—or call into question—a stock’s move. 

For example, if you’re watching a stock approach and rally above a significant resistance level on your charts, the volume on which it breaches the resistance level might tell you something about the strength and conviction of the rally.

A dramatic increase in up volume relative to the stock’s average trading volume might be telling you that there are a significant number of new buyers at that level—perhaps enough to sustain the move and keep the stock from retreating. 

If that happens, you might have a better risk/reward ratio for holding or adding to an existing position. Conversely, if a breakout happens on low or weak volume, the chances are greater that the move is false, and that the stock may retrace back into its previous price zone. 

Volume records could also be important when trying to find an entry point for a stock on a pullback. As price reaches a support area, you want to see an extreme dry-up in volume. Some traders see this as an indication that existing sellers are exhausted and are unlikely to push price below that support level. 

If price should break below that support, and volume increases, that’s a sign to consider exiting a position. Or, if you were looking at that level as an entry point, you may wish to reconsider.

Breaking the Sound Barrier

A simple way to use volume is to plot it at the bottom of your chart using green bars for up price moves and red bars for down price moves. It won’t take long before you’ll get a feel for volume patterns and how they coincide with price movement.

Volume-weighted average price, or VWAP, is a more advanced way of looking at volume. VWAP is calculated by taking the total dollar amount of transactions in a stock during a specified time period—usually one day—and then dividing it by the total number of shares traded in that same time period. The idea is that if you buy at a price lower than the VWAP, it’s a good entry, and if higher than the VWAP, well, not so much.

Large institutional investors, who need to move big blocks of stock in and out of the market, often key off the VWAP to place their trades in a way that will be least disruptive to price. Individual investors looking to build a long-term position in a stock can take advantage of this dynamic by regularly buying below the VWAP in an attempt to achieve a better average cost basis.

Day traders often use VWAP in their trading as well, buying when the indicator breaks its intraday moving average, as this can be a sign that momentum in a stock is shifting from bearish to bullish. 

While this article discusses aspects of technical analysis, other approaches, including fundamental analysis, may assert very different views. Past performance is no guarantee of future performance.