One measure of demand for buying or selling a security is its trading volume. In general, higher trading volume supports strong price movement. But how do investors know when volume is really high? Like many other metrics such as price-to-earnings (P/E) ratio, trading volume varies for different stocks and different sectors. That’s where investors can look to a stock’s average daily trading volume.
This article will help you understand the average daily trading volume, what it can tell investors, what causes it to change significantly, and how it can be used as part of a trading system.
What is Average Daily Trading Volume?
The average daily trading volume (ADTV) is simply the average amount of shares traded each day for an equity. To calculate ADTV, find the total volume of shares traded over a certain period of time and divide that number by the desired time period. The most commonly used time frames associated with ADTV are monthly, quarterly, and yearly (annual).
Most financial websites and trading platforms provide the average daily trading volume for a security. Additionally, stock charts can show you volume as it relates to price movement. This gives investors a clear picture of specific patterns related to trading volume.
Why is Average Daily Trading Volume Significant?
Average daily trading volume is significant in the same way that a simple moving average (SMA) is significant. The SMA smooths out price movement. The ADTV smooths out volume. On any given day, a security may have higher or lower trading volume for any number of reasons. Knowing the ADTV gives investors a clearer understanding of investor sentiment.
What an Increase in ADTV Means - Average daily trading volume tells investors how much interest a security is generating. This helps them determine the liquidity of that security (i.e. how easy it is to trade). Simply put, an average daily trading volume that is increasing means there is a significant commitment by traders. This tells traders that there are many available buyers and sellers, making it easy to execute a trade.
When the price of an equity is consolidating, investors want to see evidence of higher-than-average trading volume along with a rising stock price. This is a bullish signal because it confirms that more buyers are entering the market.
What a decline in ADTV means - Typically a downturn in average daily trading volume means that there is less enthusiasm about a particular security. This means that there are fewer committed buyers. And that means there is less liquidity in that security. For a day trader looking to enter an exit a position quickly, a security that is seeing a downturn in ADTV may be more difficult to buy and sell quickly.
For short sellers, a lower-than-average trading volume along with a falling stock price means that there may not be sufficient downward pressure on the stock to execute a trade. Conversely, long investors may view a stock price that is falling on low volume as an opportunity to accumulate more shares because selling pressure is not that strong.
What Are Reasons For Changes in Trading Volume?
Here are a few examples of situations that may affect the average daily trading volume of a given security:
- An upcoming earnings report – Trading volume tends to go up in a stock in the period immediately before and after it releases earnings. If analysts and investors expect a company to post better-than-expected earnings, buying demand will increase. Conversely, if a company is expected to report disappointing earnings, selling pressure will increase.
- An upcoming ex-dividend date – For dividend-paying stocks, trading volume will typically increase prior to the company’s ex-dividend date. The ex-dividend date is the date before which an investor must be a shareholder of record in order to receive a dividend payment.
- Analyst reports – Trading volume may move higher or lower in response when analysts issue a new revision to a stock and/or their price target for the stock.
- News coverage – A company can make news for positive and negative reasons. Depending on the reason for the news coverage, trading volume may move higher or lower.
- Changes in institutional buying – There are times of year, specifically the period between June through August that institutional investors are less active in the market. During this time, you may see prices changing based on significantly below average volume.
Should Buy-and-Hold Investors Focus on ADTV?
Average daily trading volume is a technical indicator. Technical analysis is a trading strategy that is used by active traders to determine when to enter (buy) or exit (sell) a position. These investors are typically looking to buy and sell a security, often times in the same day. For that reason, they use average daily trading volume to select securities.
Investors with a long position in a stock are generally more interested in fundamental analysis. That means a monthly or quarterly ADTV does not hold much significance. However, if the annual ADTV has been trending lower over a number of years, it may be a sign that there are other problems with the stock.
How Traders Use ADTV
Investors who use annual daily trading volume in their trading understand that the relationship between volume and price comes down to supply and demand.
When investors want to buy or sell a stock, there has to be investors on the other end of that trade. The average daily trading volume can signal to an investor that an event has occurred that is causing trading demand to increase.
But simply knowing that there is trading demand is not sufficient. While average daily trading volume can help confirm to a trader that a security is being actively traded, it does not, by itself, indicate price movement one way or another. There can be both high buying volume and high selling volume.
This is why, as part of a trading system, average trading volume is always secondary to price. To make a more informed decision about what the average daily trading volume means, investors will look at price movement. Here are a few ways that investors use volume in their trading:
To Confirm Convergence - When the price is moving in the same direction as volume (that is the price is rising when volume is increasing or conversely the price is falling as demand is decreasing), that is called convergence. This is a good indicator that a trend is likely to continue and prices are likely to continue in the direction they are going.
To Confirm Divergence - When the price of a security is moving in the opposite direction from its volume this is called divergence and it generally means that any trend that was associated with the security is weakening. If price is rising as demand is falling it may mean that support for a price is losing steam. If the opposite is happening and price is falling but demand is rising, it could be a clue that the stock may be ready to rally.
To Observe What Happens When Price Meets Resistance - In any rally, prices will reach a level where buyers take a breather. This is called a resistance level. In order for prices to move past this level, there has to be significant volume. Therefore, traders look at securities that are trading above the average daily trading volume because they are more likely to push past a resistance level.
- If the price continues to advance beyond a resistance level and the security continues to have an above average volume – This is a bullish signal that implies investors are enthusiastic. And enthusiasm leads to more buying and a price that will continue to climb.
- If the price continues to fall below a resistance level and continues to have an above average volume – This is a bullish signal for short sellers because the combination of negative price movement with advancing volume signifies a high level of investor anxiety. This is likely to produce more selling and a price that will continue to decline.
Some Final Thoughts on Average Daily Trading Volume
Average daily trading volume (ADTV) is the average amount of shares traded each day for an equity. ADTV is a technical indicator that gives investors a snapshot of the liquidity in a stock over a specific time period (usually monthly, quarterly, or annually).
An informed investor can and should, at the very least, be aware of what an average daily trading is and what it may be saying about their investment. But the extent to which it impacts their trading habits really depends on what kind of investor they are.
ADTV is only one data point that investors use. But as this article shows it can tell investors and traders a great deal about investor sentiment. Understanding that sentiment helps minimize risk by pointing investors towards stocks that have liquidity (i.e. a committed group of buyers and sellers). However, ADTV is always secondary to price movement. Ultimately investors want to see both high demand for a stock and strong price movement.
