Volume Analysis: Meaning, Indicators, How To Use, Importance and Limitation

"We Will Rock You" - is a song written by Brian May and performed by Queen, a British rock band, as part of their 1977 album News of the World. A song that continues to play at parties and remains one of the greatest songs ever produced. If you look at it objectively, what got and still gets the crowd grooving is the vitality or the vibe the song generates with its rhythmic beats when the audience involves themselves all together in the clapping ritual. Let's cut to a mall or a marketplace. The volume of footsteps echoes the enthusiasm of the buyers and sellers. When it's bustling, business is generally good,  right? Volume may be called the heartbeat of a market, revealing its vitality. 

In technical analysis of stock markets, volume is a powerful tool that unveils the intensity of market moves.

This concept, combined with price analysis, discloses crucial information about the strength and direction of a price trend. With information on volumes, traders can identify periods of high and low activities and assess the potential shifts in supply and demand. The volume also helps traders gauge the liquidity in the market and make more refined trade strategies. 

Let’s begin this chapter by first understanding what volume means. We shall later cover volume indicators and how you can deploy them to create successful trade strategies.

Understanding Volume in Stock Market

Volume is a fundamental concept in the stock market that plays a crucial role in helping understand market behaviour and make informed decisions. Volume, in simpler terms, refers to the number of shares traded during a specific period, such as a day, week, or month. For instance, say 70,000 shares of a certain company are bought and  30,000 shares are sold in a day,  then the intraday volume of that company is 1,00,000. 

Volume can provide valuable insights into market activity and the level of interest or participation in a particular stock. Imagine you are at the cricket stadium, attending an IPL match. Fans are passionately cheering for their favourite teams all around you. The louder and more energetic the crowd gets, the more intense the atmosphere becomes. Now, think of each cheer as a trade in the stock market. When there’s a lot of cheering (trades), it indicates a lot of active participation in the market. 

By analysing volume, investors can gauge the strength of price movements and identify potential trends. 

But volume can never be linear. Can it? A variety of factors can influence it, and it is typically demarcated into two types – High-volume and low-volume

• High volume

High volume occurs when there is a significant surge in trading activity for a particular stock. Characteristics of high volume – a heightened level of investor interest and substantial price movement. 

So, when volumes are high, it suggests many buyers and sellers are actively participating in the markets, and there is increased liquidity. Now, this can happen due to ‘n’ reasons - positive news, earnings reports, macroeconomic factors, etc. For better understanding, let’s take an example. Assume stock X just announced quarterly, beating all market estimates. Now, investors may be attracted to stock X, and as a result, they may be buying the stock, causing a spike in volumes. Traders here can deploy various strategies and make profits. 

• Low volume

The concept of low volume is directly opposite of high volume. Low volumes occur when there is a decrease in trading activity in a particular stock. It indicates a lack of interest and investor participation. It can also indicate low liquidity. Low activity can be due to a variety of reasons, such as the holiday season, negative news and more. 

But can a stock price move up with low volumes, or can a stock price fall and have high volumes? Yes, it can happen and is quite common in markets. 

Take a look at the table below – 

Price movement	Volume movement	Interpretation
Upward	High	Strong bullish
Upward	Low	Weak bullish
Downward	High	Strong bearish
Downward	Down	Weak bearish

 

This table should give you an idea of how volume is typically interpreted. Prices can be up, but volumes can still be low and high; prices can be down, and volumes can still be low and high. Basically, volume can be one determinant of bull and bear markets.

Now that you understand volume, the question in your mind (and rightfully) must be – how does one measure volume? Is there a tool, indicator or way of analysis? Well, there actually is, and they are called volume indicators. 

Let’s read more about volume indicators and how you can deploy them while trading.

What Are Volume Indicators in Stock Market?

Volume indicators are tools used to measure the number of shares of contracts traded during a given period of time. They provide insights into the strength and direction of market trends. In other words, volume indicators quantify the level of activity and intensity in the market during a certain time period. So, by analysing volume using these indicators, you can get a good idea of the level of enthusiasm and interest a particular stock is generating. 

Volume indicators are typically displayed as bars or lines on charts for particular time frames such as a day, week, month and so on. Take a look at the image below for reference. 

Volume indicators are particularly valuable when used in conjunction with other technical and price analysis tools, such as moving averages, RSI (Relative Strength Index) and more. Now, you must note that volume indicators identify not just patterns and trends but also potential turning points, such as convergence and divergence, which can further help validate or negate a trend. We’ll read more about this below, but let's first figure out the top volume indicators traders use in today’s markets. 

What Is On-Balance Volume Indicator in Stock Market?

The On Balance Volume (OBV) is arguably the most popular volume indicator that helps assess a security's buying and selling pressure. It does this by considering the total volume, which implies adding up volume on days when the price goes up and subtracting it on days when the price goes down. In other words, using the positive and negative volume flow, this indicator tries to understand the buying and selling pressure in a particular stock.

Joe Granville formulated OBV in his book called Granville’s New Key to Stock Market Profits. Published in 1963, this indicator was viewed as significant because it was one of the first to track the flow of volume in and out of stock. Remember we learnt about volume and its importance? Granville, in the same context, argued that volume is a key determinant of price movement. 

OBV can help verify if the volume of trading activity supports the current trend in price. Also, by comparing OBV with the price movement, you can spot price trends, divergence and convergence too. What is divergence and convergence, you ask? Simply put, divergence is when two subjects move in different directions. In the context of the OBV, divergence can be between the price and OBV line. For example, if the price is going down but the OBV is going up, it could indicate a potential price reversal in the current trend. On the other hand, if the prices and OBV line move in the same direction, it can confirm the current price trend, and that movement together is what you call convergence. 

How is the OBV Indicator Calculated? 

The OBV line is a straightforward way to track positive and negative market volume; think of it as more like keeping a running Tally. Here’s how it works – If today’s closing price is higher than yesterday’s, then you add today’s trading volume to the running total (OBV). In other words, if the closing price is above the prior close price, then 

Current OBV = Previous OBV + Current Volume

But what if the closing price is below the previous day? Well, in that case, you simply subtract today’s volume. 

Current OBV = Previous OBV - Current Volume

And if prices stay the same? Then, the OBV remains unchanged

Current OBV = Previous OBV (no change)

Let’s understand this with an example.

Date	Close	Up/Down	Volume (shown as 1000’s)	Positive /Negative	OBV
2 Dec	50
3 Dec	52	(+1)	7,000	(+7,000)	7,000
4 Dec	53	(+1)	8,000	(+8,000)	15,000
5 Dec	51	(-1)	6,000	(-6,000)	9,000
6 Dec	52	(+1)	6,500	(+6,500)	15,500
7 Dec	54	(+1)	9,000	(+9,000)	24,500
8 Dec	53	(-1)	8,000	(-8,000)	16,500
9 Dec	55	(+1)	9,500	(+9,500)	26,000
10 Dec	56	(+1)	9,700	(+9,700)	35,700

 

This is the closing data of an imaginary stock X from Dec 2nd to Dec 10th. Volume has been rounded off and depicted in the 1000s (7,000 here means 7,200,000 or 7.2 million shares). You first determine if the stock X has closed up (+1) or down (-1). This number is used as a volume multiplier. The last column is the OBV, which is derived by adding or subtracting the volume from the previous day’s OBV, depending on the closing (add if positive, subtract if negative).

How To Use On-Balance Volume Indicators in Trading?

Now that you understand how the OBV line is calculated, let’s see how to employ it in real-time. 

1. Start by analysing the OBV line. If it rises, it can suggest that buying pressure is stronger, indicating a bullish trend. Conversely, a declining OBV line may indicate a bearish trend. 
2. Now, compare the OBV trend with the price movement. If both move in the same direction, i.e., converging, it may indicate a bullish trend (as it confirms the strength). A divergence may happen if they do not move in the same direction. 
3. You can look for breakouts with the help of the OBV indicator. For instance, if the volume is rising sharply but prices are not, there may be a breakout on the horizon.
4. Do not forget to confirm the strength alongside other indicators such as trend lines, moving averages and more. 
5. Set appropriate stop loss based on your analysis and risk appetite. This can help manage profits while minimising risks. 

Significance of Volume Indicators in Trading

By now, you must be confident about what volume means and how indicators like OBV function. You may also have understood how they are important to technical analysis. Let’s further understand why volume indicators such as OBV are a popular choice amongst investors and the benefits they offer. 

Volume indicators such as OBV are often used to confirm price movements. When volume increases alongside a price trend, it can suggest strong buying pressure and reinforce the upward momentum. Conversely, increasing volume during a downtrend can indicate heightened selling pressure, validating a downward movement. By analysing volume in conjunction with price, traders can gauge the reliability of a trend and make informed decisions. 

Another significant advantage of using volume indicators is that they can help identify market reversals. The divergence between price and volume can serve as a warning sign of a trend losing momentum. For instance, if the prices are rising while volume is decreasing, it may indicate a weakening bullish trend. Similarly, if prices and volume are both down, it may depict a waning bearish trend. Recognising these divergences can help traders anticipate trend reversals and adjust strategies accordingly.

Volume indicators also find significant employment when gauging breakouts and breakdowns. Breakouts occur when prices surpass a significant resistance level, and breakdowns occur when prices fall past below a crucial support level. When a surge in volume accompanies these breakouts and breakdowns, it lends credibility to price movement, indicating increased market participation and potentially signalling the start of a new trend. Traders and investors can use volume indicators to confirm the validity of the price levels and make trade decisions. 

Lastly, volume indicators are not very complex to understand. They offer a straightforward analysis of the strength of the current trend. And for the same reason, they are popular with investors and traders alike.

Limitations of Volume Indicators in Trading

As you must have understood by now, volume indicators such as OBV play a critical role in price analysis and prediction and help understand the sustainability and strength of a trend. However, the volume indicators are not without their limitations and constraints. Read below the limitation of volume indicators before you deploy them for trading. 

Most volume indicators are lagging in nature because they use historical data. Think of them as an echo in a canyon. For the same reason, they may fail to provide real-time insights into market movements. In fast-moving markets, they may, thus, be less useful. 

A glaring limitation of volume indicators, including OBV, is their inability to provide reasons behind the volume change, that is, they cannot reveal the motivation of market participants. For example, high volume may be indicative of strong buying interest or increased speculative trading. In both cases, a trader using a volume indicator may not understand the underlying reason for the market’s movement in a particular direction. Thus, OBV and other volume indicators are not infallible predictors of price indicators. Without additional analysis and context here, it can be challenging to navigate the markets. It, therefore, mandates using other technical indicators and fundamental factors to validate volume. 

Also, some market participants with significant resources (like shark investors and big AMCs) can influence and manipulate volume levels to falsely perceive market sentiment. This can distort the volume indicators' interpretations and readings, which may lead to unwise trading decisions. 

Another limitation of volume indicators, including OBV, is that they may be less effective in markets with lower liquidity. In illiquid markets, the volume data alone may not accurately reflect the true supply and demand dynamics. Small trades or low trading actively may result in misleading volume patterns, making it challenging to draw reliable conclusions from volume indicators only. 

One limitation specific to the OBV indicator is its sensitivity to minor price fluctuations. You know that OBV accumulates volume based on the direction of price movements, adding volume on days the volume goes up and subtracting on down days. Now, imagine the OBV indicator when markets move sideways i.e., has continuously minor fluctuations! In such situations, there can be erratic swings in the OBC line, which might not really tell you if the stock is on a clear winning or losing streak. 

Lastly, OBV indicators may not be effective in detecting divergence when compared to other indicators, such as the RSI (Relative Strength Index) or MACD (Moving Average Convergence Divergence). In other words, volume indicators cannot be considered standalone tools that can give the complete picture of a trend movement.  

This brings us to the end of this chapter. Hope it was as enlightening as it was engaging! Before we move on to the next topic, here’s a quick dig into all that we learnt here today: 

Volume plays a crucial role in stock market analysis, reflecting the trading activity within a specific timeframe. High volume indicates active trading and liquidity, while low volume suggests reduced interest. Volume indicators, with the On Balance Volume (OBV) being a popular choice, gauge stock pressure by tracking volume inflow and outflow. A rising OBV may indicate a bullish trend, while divergence from price can signal potential trend reversals. These volume indicators serve to confirm price movements, aid in trend identification, and assist in recognising breakouts and breakdowns. However, it's important to note that volume indicators have limitations, including lagging, inability to explain volume changes, susceptibility to market manipulation, and less effectiveness in illiquid markets.