Why Volume Is Important for Investors

12/20/2011 6:30 am EST

Focus: STRATEGIES

Buff Dormeier

Senior Vice President - Investment Officer, Wells Fargo Advisors

Buff Dormeier, who has written a critically acclaimed book on using volume analysis in your investing, explains here why volume is so important.

Buff, I understand you’ve written a book, Investing with Volume Analysis. Tell me about it.

Thank you, Karen. Yes, the book is Investing with Volume Analysis, and what I’ve tried to do with the book is to try to take a subject that is really underutilized and underappreciated in the market analysis, which is volume.

Many people focus on price and fundamental analysis, but what many people often neglect is price’s sibling, which is volume. So what we try to do with the book is really cover the subject of volume and understand why that is so important in our investing decisions.

How can investors use volume?

Well, volume is an important piece of information. It represents how many people are participating at any given point in time.

Markets move in trends. If a market is trending, let’s say it’s trending higher, that trend needs more and more people willing to participate at ever-increasing prices in order for that trend to continue.

 So it kind of reflects the, if I can say, herd mentality of the market?

I like to think of it, as opposed to a herd mentality, the fuel of the market.

You can kind of compare a market trend and the fuel to maybe a plane in mid-flight. If a plane is flying, to maintain its flight it needs to maintain a minimum air speed. Now if you want to change the trajectory of that plane, the pilot will change the trajectory and then he will apply thrust. If that pilot does not apply the thrust, that plane is likely to stall.

The same thing can be said with the market trend. If the market starts moving higher and it does not get increased fuel by more investors willing to participate at those higher prices, it’s subject to its own correction.

What happens when you go through, say, the month of August, where a lot of people are on vacation and you don’t have the volume? What does that tell you?

With a lack of volume, it means that whatever that trend is, it is subject to correction.

So in August, the market was trending down. Actually the volume was quite high on the down moves. That means that there was a lot of fear in the marketplace and many people were looking to sell.

On the preceding rebound, there was not a lot of volume. So what that told you is it’s kind of like playing poker and there’s a tell. If you know that there isn’t volume there, it’s a tell of the market that that new trend is subject for correction.

So going forward, how can I use volume in my investment decisions?

Well the easiest way is just to look at the bottom of your chart. You’re already looking at price, now you just need to look at those other bars on the very bottom, which are volume. If you see the trend of those volume bars moving higher, that tells you that there’s indeed participation.

If you see participation, it’s more than likely that trend is likely to continue. If you don’t see it, then that’s giving you a warning sign or the market is giving you its tell that that trend, whatever direction, it may be a bluff.

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