For too long I had a tendency to look only at the price a stock was trading at. I would primarily look at daily charts, then switching down to 15 minute charts if I was going to day-trade this stock. If my goal was to swing-trade, then I would stay with the dailies, except for the actual execution, where I would switch to a 5 minute chart after first reviewing the 15 minute chart.
During all of this, I might glance at the volume, but I never really took a deep look, or study, at it. I believe now that my trading suffered as a consequence to this. Since paying more attention to volume, my trading, as measured by my profits, has improved.
I believe that volume leads the price, at least in terms of importance. If I can locate an unusual volume in a stock, then I want to know what the stock is doing - is it going up, or is it going down. The increase in volume says that something important is going on. Once I know something important is happening, then my next question is, what is going on? This is answered by looking at the price; is it going up, is it going down, or is it trading very close to the same price. All three of these can happen on a change in volume.
The first assumption, with respect to volume, is that it has to have increased, above its normal value (an average), for it to be important. However, it is also important to recognize if a volume has significantly dropped below its normal value. This should also be taken in context of the market volume (e.g., SPY) as a whole, with a good idea to take a look at the sector this stock belongs to and its volume.
Volume Increasing, price going up - under construction
Volume Increasing, price staying the same - under construction
Volume Increasing, price going down - under construction
Volume Decreasing, price going up - under construction
Volume Decreasing, price staying the same - under construction
Volume Decreasing, price going down - under construction
Volume Average, price going up - under construction
Volume Average, price staying the same - under construction
Volume Average, price going down - under construction
An Analogy - restaurant volume and trading insight
After watching some of Gordon Ramsey's "Kitchen Nightmares" shows on TV, we have started to avoid restaurants with low customer volume. On Ramsey's shows, invariably those restaurants with low customer volume, are trying to hold over their food far past the dates when the food should have been discarded for safety reasons, let alone taste reasons!
So, while I was tending to ignore volume in my trading, I was paying increasing attention to volume at restaurants.
And this leads me to my analogy on trading and restaurants!
Assume I had only had access to the average price paid for a meal at a restaurant, but no information about the number of customers that bought meals that day. Charting the average price of meals at that restaurant, assume my chart shows this daily meal price average to be $12.50.
On this new day, assume they only had one customer for the entire day, and he spent lavishly, paying $100 for lunch. The average price of the meals for that day would be $100. So, looking at my charts for the average daily sales price of meals, I would observe a huge spike in the price - from $12.50 to $100! I would be very interested in stock for this restaurant!
However, by adding volume into the information I'm obtaining regarding the sales of meals at this restaurant, instead of being interested in buying the stock for this restaurant, I might have an entirely different opinion: I might conclude this restaurant was dying, as it only had a single customer for a whole day!
So volume adds a significant amount of relevant information to the information I use to consider whether to buy or sell-short a stock.
Volume allows me to have confidence in the price I'm observing. Not enough volume, then my confidence in the price being accurate goes down. Average volume, and my confidence in the price being accurate goes up. A significant change in the volume, and I'm interested in knowing more.
Sometimes, such as today (Monday, June 27, 2011), on a daily chart, I noted a huge volume spike in CHSI the previous trading day (Friday, June 24, 2011). This looks odd - a huge volume spike yesterday, and no increase in volume today. Investigating further, I switched to a 15 minute chart, and saw the truth. On Friday, at the end of the day, there was an increase of 10 times normal volume for this time of day. Meanwhile, the price range was within normal for the day. So there is a disconnect between the price movement and the volume movement. So, the volume, since it was a spike and not uniform across the day, leads me to discount the quality of this information - I don't think I can effectively use this increase in volume. This, coupled with a non-linear response in the price, where it didn't also move considerably, again leads me to conclude there isn't much tradable information being presented, so I do nothing with this stock.
Today, this stock is continuing in its normal trend, which it started on Thursday, on average volume.