Volume is the cause, price is the effect

Volume is the cause, price is the effect There has been a lot of chatter recently about trading volume (or lack thereof). Specifically, the popular topic of discussion has been how particularly abysmal volume was during the month of August.

While seasonal volume trends are important and can have an effect on prices as well as price movement (volatility), I thought now would be a perfect time to offer some basic insight on volume, how to read it, and the dangers of trading a “low-volume” stock.

I have to give credit to an old friend for coining the term, “Volume is the cause and price is the effect,” because it really sums up volume’s function. In the stock market, prices don’t typically change unless someone steps into the marketplace and either bids a stock price higher or offers it lower (just like a transaction on eBay won’t happen with just a seller offering a price; a buyer needs to match it).

When a buyer and seller match in the stock market, a trade is made and the volume is recorded. Of course, nowadays, this happens thousands of times a second in the broad markets. But let’s step back for a minute and look at how the system actually works at the most basic level.

Take fictional stock ABC Corp., which closed last night at $20.00. Let’s assume that ABC is thinly traded, meaning there are not a ton of market participants that trade the stock. You are the proud owner of 1,000 shares of stock in ABC, which normally only trades about 10,000 shares per day (this would be considered extremely low volume).

With the stock now at $20, you are willing to sell your shares that you bought a year ago for $17. If you were to enter a market order to sell all 1,000 shares, you definitely run the risk of driving the price down. This is partially where market makers come in.

Market makers are there to provide liquidity and help stabilize prices, but like the rest of us, they want to make money. Let’s assume there are two market makers in the stock. Market Maker A has a bid of $20 (which is the current best bid you see) for 100 shares, then Market Maker A’s next bid is $19 for 100 shares, then $15 for 1,000 shares. Market Maker B has a bid for $19 for 100 shares, $18 for 100 shares, and $16 for 500 shares.

Market makers want to spread out their risk, and the more they are willing to buy, the less they are willing to spend. (In this example, the first market maker doesn’t want to buy more than 100 shares for $20 but is willing to buy 1,000 shares for $15). By the way, you can see the “depth” of the markets by looking at a NASDAQ level-2 screen.

Market makers are essentially just traders entering bids and offers like the rest of us. Their bids are essentially limit orders they have set in place at prices at which they are comfortable buying.

Let’s get back to your market order. If you hit the “sell” button for your 1,000 shares, where will your order be filled? Here is how it would likely trade:

100 shares get filled at $20 (Market Maker A)
200 shares at $19 (100 shares bought by each market maker)
100 shares at $18 (Market Maker B)
500 shares at $16 (Market Maker B)
The last 100 shares at $15 (Market Maker A)

ABC is now trading at $15, thanks in large part to your dumping 1,000 shares. Your average sale price would be $17.15, which is 15% less than where you thought you were selling at and now you just barely broke even (remember you owned ABC at $17).

See how volume created the price move? This may be an extreme example, but it is the reason why prices change. If there is an imbalance of buyers versus sellers, the price may increase (or vice-versa).

It’s not just market makers that buy and sell stock, of course. It’s also other investors like you and me with varying opinions that create the marketplace with our limit and market orders to buy and sell.

Do you think if there were more market participants the price might be less volatile? The answer is yes; the more market participants, the more stable stock prices tend to be in reaction to buy or sell orders. Now that is not to say that if there is a catastrophic news event, highly liquid stocks can’t be volatile, but at least you will have a better shot at exiting your position.

Liquidity is also the reason we have stock exchanges themselves. They act as a central meeting place for all buyers and sellers of stocks. Think about it, if you want to sell that vintage Mark McGwire rookie card for the best price, would you put an ad in the local paper, or go to a marketplace like eBay, where you can ensure that thousands of eyeballs from all over the world will be looking at your product?

The bottom line is that it is typically preferable to be in higher-volume, more liquid stocks (average volume of at least one million shares per day). This will not only help ensure you can enter and exit trades efficiently, but can mean sufficient liquidity in the options markets as well.

Photo Credit: humbert15

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