When the value of Sam Walton's Wal-Mart stock lost $500 million during the 1987 stock market crash, the folksy billionaire reportedly said, "It's only paper." A heavy volume price drop might result in only a paper loss, but stocks are more than just a line item on your balance sheet – they represent ownership in the company. The reason behind the heavy volume could be the deciding factor on whether you hold or sell your stock.
When there is a heavy volume price drop, this means that there are more stock shares available than buyers who want to purchase those shares at the current trading price.
Defining Trading Volume
Volume refers to the number of shares of stock that trade. Most stocks trade within a predictable volume range each day, and some stocks normally trade a greater number of shares than other stocks. The more thinly traded a stock is, the harder it is to predict volume.
If trading volume significantly increases in a particular stock, there's usually a reason for it. That reason can be as significant as a major change in management, or as inconsequential as programmed trading based on computer models.
Interpreting Price Drops
A heavy volume price drop means only one thing for certain: There are more shares available for sale than there are willing buyers at the current price. It could mean that a lot of shareholders are dumping their stock, or it could be that a major shareholder has decided to sell a large block of shares. The law of supply and demand takes over, forcing the stock's market price lower.
Understanding the Role of Emotion
The stock market can be driven by emotions. Fear sometimes sets in when investors see a large volume price drop. They might try to sell their shares for fear that the price will drop lower, and this increases the downward pressure on the stock. If the price drops below a predetermined level, computer programmed selling kicks in. This additional sell volume continues to fuel the supply/demand imbalance and forces the stock price even lower, until the stock reaches a price support level where potential buyers feel comfortable.
Identifying the Consequences
As long as the company's fundamentals are sound, a heavy volume-fueled price drop can create an excellent opportunity to buy stocks at bargain-basement prices. If you employ a buy-and-hold investment philosophy, changes in your stock's market price either up or down are immaterial, because you're in it for the long haul.
It's a different matter if there's a fundamental reason why investors are dumping the stock. For example, if the company has filed for bankruptcy or just got hit with a major lawsuit, it might be appropriate to cut your losses by selling at the going price. And, if the price drop involves a stock you hold in a margin account, the decreased value of your stock could put you at risk for a margin call. In more extreme situations, you may find that a catastrophic incident such as bankruptcy has rendered your shares worthless.
The examples included previously are all risks that shareholders accept when choosing to invest in a company.
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