The Role of Trading Volumes in Analyzing Market Strength
The trading volume reflects market activity. There is no centralized volume data in over-the-counter (OTC) markets like forex. However, understanding market sentiment, often gauged by analyzing trends in other asset classes, is crucial for gaining insights and making informed decisions.
Volume Analysis in Stocks
In a centralized market such as equities, trading volume represents the total number of shares traded, offering valuable insights into market sentiment, liquidity, and the strength of price movements.
In the U.S., the S&P 500 Index serves as a powerful gauge, representing the performance of 500 large publicly traded companies. A rise in the index typically reflects optimism among investors, and currency pairs like AUD/JPY tend to appreciate in such an environment. Conversely, a decline in the S&P 500 signals market pessimism, which can lead to a rise in safe-haven currencies such as the USD, CHF, or JPY.
Chart 1: Amazon daily volumes. Source: Barchart.com
The Amazon chart above clearly shows that price volatility often increases on days of higher trading volumes, producing reversals, gaps, and other chart patterns. These days likely align with the release of substantial company-related information (such as earnings reports) or broader market news (progress on the U.S.-China trade negotiations).
Traders typically identify periods of heightened activity by comparing actual trading volumes to average volumes. A significant deviation from the norm would be evident if Amazon’s traded shares spiked to 10 million in a recent session, compared to an average daily volume of 3 million shares.
Interpreting volume data is a crucial aspect of market analysis. In the example above, high trading volume often triggers sharper price movements, whether in line with the main trend or as a price correction.
Interpreting Volume Data
High volumes, high price change
High volumes often start the formation of classic reversal or continuation chart patterns. Their signal is more indicative when volumes lead to significant price changes.
High volumes, no or low price change
Sometimes, large trading volumes fail to move prices, suggesting a balanced view between buyers and sellers regarding the new data. It’s essential to analyze the underlying factors driving this increased activity.
Low volumes, high price change
Another scenario involves sharp price changes occurring during periods of low volume. This behavior is typical for corrections against the primary trend. As the correction nears its end, trading activity usually picks up, pushing the stock back in the direction of the main trend.
Example: SPDR S&P 500 ETF (SPY)
Now, let’s examine the volume data for the SPDR S&P 500 ETF (SPY), which replicates the returns of the S&P 500 index. This highly liquid ETF manages over $400 billion in assets and is actively traded by both institutional and retail investors. We’ll see how price movements have responded to periods of higher trading volume.
Chart 2: SPY ETF Volume Chart. Source: Marketwatch.com
The S&P 500 has generally followed an upward trend in 2019 (Chart 2). On days of heightened trading activity, interesting price patterns have often emerged. In the period August-September, increased trading volumes led to multiple attempts to break below the main upward trendline. A more sustained recovery occurred in October, driven by a breakthrough in U.S.-China trade negotiations.
More aggressive long traders recognized this high-probability opportunity, which emerged around critical trendline support, increased trading volumes, previous bottoms and positive developments from the trade talks. The alignment of fundamental, technical, and volume analyses generated market optimism, fostering a risk-on environment.
Conversely, on December 20th, the trading volume reached its highest level around Christmas but did not lead to a significant price movement. This was likely due to year-end portfolio rebalancing for tax or accounting purposes, with no new fundamental information affecting the market.
Applying Equity Volumes to Forex Trading
Rising equity markets generally reflect positive economic expectations and increased risk appetite, leading to an appreciation of risky assets. Conversely, falling equity markets indicate a low-risk appetite, prompting investors to seek safer assets.
For example, the upward trend of SPY starting in October would typically be accompanied by an appreciation of currency pairs like AUD/JPY.
Global events, such as the U.S.-China trade conflict, can trigger heightened trading activity not only in the U.S. and China but also across major exchanges worldwide.
Regional events like Brexit have impacted mainly the UK and European financial markets. In such cases, the trading volumes of British stocks and the price movements of the FTSE 250 Index becomes the priority of analysis.
The EURO STOXX 600 and the German DAX 40 indexes often serve as indicators of the broader European economy, while in Japan, the focus typically centers on Nikkei 225 or TOPIX 100. Even smaller economies have stock market indices that can be used to gauge local investment sentiment.
Conclusion
Volume data provide valuable market insights for both fundamental and technical analysts.
Since foreign exchange trading is decentralized and lacks official trading activity statistics, other asset classes like equities or derivatives (futures and options) offer useful information on market activity.
