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5 Steps to Understanding Volume and Liquidity

Jun 7, 2008
Understanding that volume and liquidity will boost trading profits puts you one step closer to financial freedom. The active, professional trader should know how to act in any market, liquid or illiquid.

1. High Volume Means High Liquidity

Stocks with a high volume are very liquid, not to mention they have lower spreads between the bid and ask prices. Technical analysis works best on liquid stocks because trends are more fluid and give more data on which to base a decision. High volume stocks are preferred.

2. Late Day Breakouts and Volume

Late day breakouts occur mostly in periods of low volume. In after hours trading when most traders are back at home, the market slows and each trade affects the price more and more. While 1000 shares is a drop in the bucket during live trading sessions, it is a garden hose after hours. Day traders love to play the late day breakouts that happen after hours, even in an illiquid market.

3. Average Volume

Average volume is a great way to judge the day's trading activity. Around news releases and important events, volume will spike higher than average, giving traders a distinct advantage with entry and exit points. Day traders that prefer trading opening gaps on news releases look at average volume versus current volume to get an idea how important the news is.

4. Support and Resistance

Support and resistance lines aren't worth anything in a low volume stock. It is easier for a price to break out when volume is low. For this reason, technical analysis (including support and resistance) should only be used on high volume stocks. If a small trade can push a share price 2-3%, it should be advised that the stock will move wildly. This allows for big returns and big losses, but it's always better to err on the side of safety.

5. Momentum Trading

Illiquid stocks fly when breakouts occur. Breakouts can push volume 10-20 times the average daily volume, especially for low volume stocks. Momentum strategies work best in low volume because each tick is worth more than in a high volume stock. A few high priced trades will push the ask price higher and bids will rise to match. Day traders like to follow the momentum on illiquid stocks, as it usually gives the experienced trader huge returns.
About the Author
Leroy Rushing is an active, professional day trader; trading coach; and author. He is the Founder and CEO of Trading EveryDay, a provider of educational trading products and services that are available worldwide. Trading EveryDay has complimentary/FREE products, a Tools of the Trade eBook and a Trading Room Report , that are downloadable for your convenience.
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