Having sufficient trading volume in the stocks and ETFs you trade helps ensure liquidity in your transactions. In this article, we share our top tips for determining “how much volume is enough?”
Trading volume is the total number of shares of a security that was traded in a market during a given period of time.
The more shares that are traded each day, the higher the liquidity of that stock or ETF.
Stocks and ETFs with higher liquidity generally have a tighter spread (margin between the bid/ask price), which can aid in the profitability of your trade.
High liquidity also helps ensure there is enough demand to easily facilitate a stock trade without significantly affecting its price.
Continue reading for simple guidelines on the ideal minimum trading volume for the stocks and ETFs we trade in The Wagner Daily, our nightly swing trading newsletter.
What Is Average Daily Trading Volume? Why Does It Matter?
Average Daily Trading Volume (“ADTV”) is a measure of the number of shares traded per day, averaged over a specific period of time (we recommend 50 days).
While this is not a technical indicator that seeks to predict the future direction of an equity, it enables you to quickly assess the liquidity of a stock or ETF.
When a stock is highly liquid, you can easily enter and exit positions without directly influencing the stock’s price.
Conversely, you can know which securities to avoid because they are too illiquid to trade.
Knowing the ADTV of an equity is key because it establishes a benchmark from which to spot key volume spikes that are the footprint of institutional accumulation.
For example, if a stock has an ADTV of 500,000 shares, but suddenly trades 2,000,000 shares one day, it means volume spiked to 4 times (400%) its average daily volume level.
If such a volume surge was also accompanied by a substantial price gain for the day, it indicates banks, mutual funds, hedge funds, and other institutions were accumulating the stock.
Volume is actually one of the most powerful, reliable, and simple technical indicators for momentum trading. Here is an article that explains more about how we use it in our swing trading strategy.
4 Key Questions To Determine If A Stock Has Sufficient Trading Volume
Although ADTV by itself could be used as a concrete “line in the sand” to determine if a stock is liquid enough to trade, there are many other factors that play a part in that role.
Following are four key questions that can help you figure out whether a stock can be traded or is better left alone.
1.) How Many Shares Do I Plan To Trade? Size Matters!
If you are only planning to buy 100 shares of a stock, the ADTV of an equity basically becomes a non-issue because it will be easy to liquidate such a small position, even in a very thinly traded stock.
However, if you intend to buy 5,000 shares of that same stock, you need to more seriously consider whether or not it will be difficult to eventually exit the position with minimal slippage and volatility.
Regardless of what you may have heard, size matters (at least in this scenario).
2.) How High Is The Average Dollar Volume?
Average Dollar Volume (not to be confused with Average Daily Trading Volume) is a number that is determined by multiplying the share price of a stock times its average daily trading volume (ADTV).
For example, a $25 stock with an ADTV of 800,000 shares has exactly the same dollar volume of a $50 stock with an ADTV of just 400,000 shares. In both cases, the Average Dollar Volume is 20 million ($25 X 800,000 or $50 X 400,000).
For institutional investors and traders who rely on making big trades, Average Dollar Volume is a more important number than ADTV.
In the example above, an institutional trader would consider both of those stocks to be equal with regard to liquidity.
As a general rule of thumb, an Average Dollar Volume of 20 million or greater provides pretty good liquidity for most traders.
If you trade a very large account (and accordingly large position size), consider an average dollar volume above 80 million to be extremely liquid.
By knowing the Average Dollar Volume of a stock, you can lower your minimum ADTV requirement if the stock is trading at a higher price.
3.) How Long Do I Plan To Hold The Trade?
Are you a daytrader, swing trader, or position trader? The length of time you typically hold stocks has a direct relationship to suitable minimum volume requirements (here is comparison of trading timeframes).
A daytrader who scalps for tiny 10 or 20 cent gains should focus on trading “thick” stocks where millions of shares per day change hands–equities with tight spreads and extremely high liquidity.
On the other hand, a position trader who rides the profit in uptrending stocks for many months can trade in much thinner stocks because he/she can scale out of positions over the course of several days or weeks.
The general rule is that higher trading volume is more important with shorter trading timeframes.
4.) Am I Trading Individual Stocks Or ETFs?
In individual stocks, ADTV and/or Average Dollar Volume plays a big role in determining a stock’s liquidity.
But with ETFs (exchange traded funds), average volume levels are largely irrelevant because ETFs are open-end funds. This means new units (shares) can be created or redeemed as necessary; supply and demand therefore has little effect.
Even if an ETF has no buyers or sellers for several hours, the bid and ask prices continue to move in correlation with the market value of the ETF, which is derived from the prices of individual underlying stocks.
As such, you should be much less concerned with the average volume of an ETF than with an individual stock.
In our stock picking report, we generally use a minimum ADTV requirement of 100k-500k shares for individual stocks (depending on share size of the position), but may go as low as 50k shares for ETFs (in order to achieve greater asset class diversity).
While liquidity is not of concern when trading ETFs, you should still be aware that ETFs with a very low ADTV may have wider spreads between the bid and ask prices.
To remedy this, you may simply use limit orders in such situations. Since we trade for many points, not pennies, occasionally paying up a few cents does not bother us.
For further details on the subject of ETFs and liquidity, check out Why ETF Trading Volume Does Note Determine ETF Liquidity.
How To Quickly And Easily Determine The Liquidity Of A Stock/ETF
The fastest way to gauge the liquidity of a stock is by plotting Average Daily Trading Volume (ADTV) and Average Dollar Volume (ADV) indicators on your stock charts.
These technical indicators may not be available with some of the free charting platforms, but is no problem with more robust, direct access trading platforms such as TradeStation.
The chart below shows how a simple way to display ADTV and ADV on TradeStation charts:
The top section of this chart shows the price action (and a few moving averages), the middle shows daily volume bars and 50-day ADTV, and the bottom bars plot the Average Dollar Volume (in millions).
With an ADTV of nearly 5 million shares and an Average Dollar Volume of 315 million, this would be considered a highly liquid, “institutional friendly” stock.
Don’t Get Too Hung Up About Average Volume
If you want to avoid surprise price reactions when it comes time to close out your trades, pay attention to the ADTV and/or Average Dollar Volume of stocks.
Doing so ensures there is sufficient liquidity to prevent your trades from directly affecting the stock prices.
Nevertheless, realize that determining whether or not a stock has sufficient liquidity is not as clear-cut as merely picking an arbitrary number such as 500,000 minimum shares per day.
You also should understand that Average Dollar Volume gives a more complete and accurate picture of a stock’s liquidity than ADTV alone.
Your individual trading timeframe also plays a role in determining which stocks can be traded.
Frankly, I feel many individual retail traders get too hung up about the average daily volume of a stock.
Unless you’re a whale with a massive trading account, your individual transactions within a stock will usually have a minimal (if any) effect on the price.
It’s much more important to simply focus on buying leading stocks with strong institutional support (these stocks are typically quite liquid anyway).
If a company has a history of outstanding earnings growth, or a revolutionary product that’s selling like suntan lotion at the beach, it may even be okay to buy a thinly traded stock.
In this case, just be sure to reduce your share size to compensate for greater price volatility.
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What are your personal minimum volume requirements for stock trading? Which factors are most important to you? Drop us a comment below.