Trading volume tells investors and traders about the level of participation in the markets, and this participation is seen as a gauge of liquidity, since all markets need sufficient liquidity in order for buyers and sellers to be able to open and close trades at exactly the levels they want. Lack of liquidity causes more volatility, as prices tend to move by greater magnitude, up and down, when there is no enough liquidity, as the forces of supply and demand impact the market in a more profound way. But most importantly, when there is lack of liquidity in the markets, traders find it difficult to close trades at the desired levels, resulting in what is known as slippage and requotes. Slippage means that the trade did go through, but the price the trader got is worse than the one he was originally offered, and requoting means that the trade did not go through, it was not executed at all, and the trader was offered a new, worse price where he might have chosen to either execute the trade or not. The problems of slippage and requoting, especially in the forex market and for strategies which require high frequency trading, are strongly dependent on how the specific broker operates, and how much liquidity is this broker being provided. So a poor liquidity forex broker will typically have these problems during certain hours of the day, even at periods where trading volume is normal around the world, and market participation is good. But on low participation, holiday periods, poor liquidity impacts even the best brokers.
Trading volume can be used in many different ways by traders, they all prefer markets to have good participation, so that many investors and traders of various time frames are in the market, thereby enhancing liquidity and making trading more efficient through increased liquidity. There are times however when participation and hence trading volume falls below normal levels, this happens more during holidays, during the months where the big money managers go on holiday, such as the month of August, and on the days leading up to long, 3 day weekends in the US. Another period of notoriously low trading volume is that of the end of the year, in the days of December before markets close for Christmas. Some traders believe that participation falls as early as 10th – 12th of December. As a result of this, they do not take seriously any technical signals or market moves that take place past those dates, and they expect this to continue even during the first week of the new year.
All of these are periods of light volume and low participation are of higher risk to traders because markets tend to produce false, misleading, and confusing signals that hardly anyone can understand. Even a simple holiday weekend, not always, but most of the time, tends to be surrounded by days of such confusion. This means that just before and right after the holiday weekend, markets tend to act in nonsensical ways. Markets are already confusing enough even on high volume days, but during low volume days things can become so much worse, given all the risks that increased volatility can bring with it. These are usually false market moves, false breakouts of support and resistance, and price action which also makes indicators give more false readings.
The above chart shows the SP500 stock index and periods of noticeably low trading volume around the Christmas holidays.
Some markets are more sensitive to low trading volume problems and holiday seasons, stock markets are such markets. Other markets such as commodities and currencies are also affected, even the EURUSD currency pair, which has massive liquidity, is believed to be influenced to some degree by holiday periods in the US calendar. But stocks in the US markets are strongly affected, and this impact is directly replicated in the European stock markets, as many US stocks trade in European stock exchanges and vice versa, so markets tend to influence one another.
Traders pay attention not only to trading volume levels and volume based patterns and warnings, but also to these holiday periods. In fact, holiday periods are more accurate than trading volume in detecting periods of low investor participation in the markets. Trading volume on a day to day basis may be distorted by the trading actions of longer time frame investors and traders, who only make few large trades once in a while, these actions do in fact cause distortions in the way that volume based indicators work, hence the accuracy of these volume indicators can fail. Just by watching the trading calendar, traders can identify periods of holidays and low participation well in advance and prepare accordingly. Wise trades tend to trade at smaller size during these periods, and also be more careful about new signals showing up on the charts, especially reversals and trend starts on the daily chart. Other traders prefer not to trade at all during low participation periods, but there is no exact explanation or advice as to how to go about it.
