With a record number of retail (non-professional) investors engaging in day trading stocks in 2020, risk markets have seen historic levels of volatility, with stocks behaving in ways that thoroughly confound even the most expert of investors. This has left traders grasping at ways to get a grip on how to value stocks.
While there are countless tools and indicators used by traders to make informed trade decisions, the general tenet of stock exchange–buy low, sell high–is still the formula for securing gains in equity markets. To this effect, volume is one metric that all day traders should use when forecasting a stock’s price.
Volume is Rooted in Supply and Demand
Economics 101 teaches that when supply is greater than demand, the price goes down and when demand is greater than supply, the price goes up. When supply is equal to demand, the price will remain constant.
Consider the following elementary example to demonstrate how this point works in the stock market:
- At Company XYZ’s initial public offering (IPO), there are 100 investors who want to buy 1 share of Company XYZ at $1 per share
- If Company XYZ issues 100 shares of stock, each investor will get his or her wishes filled, and all shares will sell at $1 each
- If Company XYZ issues 200 shares of stock, the price will have to be cut to $.50 per share in order for all shares to sell, as the supply for the stock at $1 per share outpaces the demand in this scenario
- If Company XYZ issues 50 shares of stock, they can charge $2 per share and be confident all of their shares will sell, as there is not enough supply to meet the demand for the stock, and investors will be willing to pay a premium to get their piece of the company
This is why hot IPOs that offer exciting prospects for the future, such as software-as-a-service company Fastly, see prices rise rapidly. The volume of buyers is far greater than the supply of shares available, so the stock continues trading at higher prices until some sort of equilibrium between supply and demand is met.
On the flip side, companies that are in their late stages of maturity, such as Ford Motor, that may not be as well-positioned for future success, will see their share prices fall. There is a large volume of shareholders looking to dump their shares, but few buyers excited to buy, so prices have to drop lower and lower before an equilibrium is met.
Factors That Influence Volume
While the aforementioned examples illustrate how stock volume affects price on a large scale, there are other short-term factors that can lead to high-volume buying or selling on a day-to-day basis, which day traders must consider to make profitable trades. Much of this information can be accrued after-hours, leading to high volatility at the opening bell of the next session, so traders must be ready to execute when markets open and capture their gains while the getting is good:
- Social media – whether it is good news based on fact or bad news based on rumor, social media posts have a way of influencing investors in 2020. Keep an eye on social media regarding the market you are trading, as posts, tweets, and snaps can lead to huge short-term shifts in volume
- Politics – the political climate, and a company’s stance on a specific political matter, can greatly influence volume. For example, Facebook recently saw a huge selloff in response to ad boycotts that pushed prices down more than 8% in one session
- Law – stock volume can shift wildly based on news regarding the legality of a certain market. For example, marijuana stocks see huge increases in buying volume any time there is positive news about legalization, and major selloffs any time it seems like legalization may be delayed
As a way of raising capital, companies may issue new shares of stock after their IPO. This will drive share prices down, as the larger volume of shares dilutes the price of those shares already outstanding.
When a company is doing exceptionally well and does not need to raise any more capital, it may choose to buy back shares. This is seen as a reward to shareholders because their shares become more valuable due to the lower outstanding volume after the buyback.
Skylar Hammond is a writer for the True Trader group who specializes in topics such as stock trading, personal finance, and forex. He focuses on helping beginners and experts alike learn more about the market and improve their trading skills.