How Do I Know If This Stock Move Was Just Noise Or Something Bigger?

You just saw a stock increase in value by 5%. That sounds exciting, does it not? Before you rush to buy-in, there is an important number you should know: the volume. The volume tells you how many shares were traded during a certain time period. In other words, the volume tells you the difference between a legitimate price change and a false or “noise” price change. Understanding the volume has helped me to stay away from chasing after “fake breakouts,” and also given me more faith in my trades.

What is Volume?

Volume refers to the total number of shares that were exchanged during a specific time period. For example, if 2 million shares of a particular stock were traded today, then that is the stock’s volume for today.

Many charting software packages will display the volume as vertical lines at the bottom of a price chart. The taller the line, the more shares that were exchanged. Conversely, the shorter the line, the less shares that were exchanged.

Why it Matters: The price tells you where the stock is headed. The volume tells you how much confidence exists behind the price move.

High Volume vs Low Volume

High volume indicates that both buyers and sellers are active. Therefore, a stock that makes a move on high volume is more likely to be a true and sustained move.

Low volume indicates that few people are trading. Thus, a stock that makes a price move on low volume may be misleading since the price change was probably caused by a small number of trades.

To put it another way, if a stock increases by 5%, and 10 million shares were traded, then many people agree that the stock should be worth more money. However, if a stock increases by 5%, and only 100,000 shares were traded, then the price change was probably caused by only a small group of traders.

Volume Validates Price Movements

The principle is as follows: volume validates the direction of the price movements.

Good Uptrend:

  • Price goes up
  • Volume is either the same or greater than the previous day
  • This shows that the buyers are becoming increasingly confident about the potential for the stock to go even higher

Poor Uptrend (Warning Sign):

  • Price goes up
  • Volume decreases
  • Fewer buyers are involved in the price move and therefore the price move may be losing momentum

Good Downtrend:

  • Price goes down
  • Volume increases
  • Many sellers are selling their shares and thus the price is moving lower

Possible Reversal:

  • Price goes down
  • Volume decreases
  • There may be little selling left to force the price down further

If the price and volume agree, then you have confirmation. If they do not agree, then you need to be cautious.

Breakouts and Volume

One of the most valuable applications of volume is evaluating the validity of breakouts.

A breakout occurs when the stock moves above a resistance level or below a support level. Not every breakout is valid.

Valid Breakout:

  • The price moves through the resistance level
  • The volume is significantly greater than average
  • It is more likely to follow the price trend

False Breakout (Trap):

  • The price moves above the resistance level
  • The volume is less than average
  • The price usually returns to below the resistance level

I once lost money on a false breakout. Since then, I have learned to evaluate the validity of a breakout based on volume prior to entering into a trade.

Volume Matters in Comparison to Average Volume

Raw volume is meaningless unless it is compared to average volume. For example, if a stock normally trades 500,000 shares per day, and suddenly trades 2 million shares per day, then that is significant. However, if a stock normally trades 50 million shares per day, and only trades 2 million shares per day, then that is quiet.

Most software programs will display average volume (usually over the last 10 days, 20 days, or 50 days) and compare today’s volume to the average:

  • Volume 2x average or higher = significant activity
  • Volume near average = normal trading
  • Volume well below average = light participation, be careful with price moves

Unusual Volume is Often a Leading Indicator

Sometimes, the volume will spike without much of a price movement. This could indicate that there is some type of action occurring beneath the surface.

High volume along with little price movement generally means:

  • Large buyers and sellers are battling each other
  • A larger price move may occur
  • Institutional investors are buying or selling shares

Take notice of unusual volume. It is generally a leading indicator before the price reacts.

Practical Tips

  1. Always look for volume on your breakouts - If there is no volume confirmation, do not make the trade

  2. Compare today’s volume to the average - One million shares is nothing if the stock typically trades 50 million shares

  3. Watch for divergences - If price is making new highs, but volume is decreasing, that is a warning sign

  4. Volume comes before price - Unusual volume often precedes major price movements

What I Have Learned

Prior to learning the importance of volume, I ignored it. I would see a stock break out and immediately jump into the stock, only to find it reversing quickly. These were low volume “fake breakouts.”

Now, volume is one of the first items I review. It does not tell you which direction the stock will move, however it will tell you if you should believe in the price move that is currently taking place.

Price is what you see. Volume is what you believe.