ACRN Journal of Finance and Risk Perspectives Vol. 3, Issue 3, November 2014, p. 103 – 122 ISSN 2305-7394 THE NEED AND IMPORTANCE OF A VOLUME BASED INDEX Rishi Mehra1, Nikhil Srivastava2 1Corporate Partners, India 2PricewaterhouseCoopers, India Abstract: The importance of volume study has already been highlighted through various researches world-wide. Volume is studied in isolation as confidence proxy; as a liquidity parameter; depth assessment indicator, whereas, volume when studied along with other parameters such as price or returns, reveals interesting conclusions like price direction, momentum, etc. All these have been several times estimated and proven. The empirical results by some of these research initiatives conclude the imperative presence of Volume in market analysis and forecasting. Volumes were and till date are studied in absolute terms for various time intervals. These intervals (normally daily volumes) reveals discontinued pattern of observations. By discontinued pattern of observations we mean the volumes start with zero and cumulate for a day and next day again starts with a zero. The study of such data poses lots of limitations and hindrances in day to day decision making such as relative understanding of volumes patterns, time series analysis and relative analysis of volume with price direction. The aforesaid limitations can be mitigated if volumes studies get reinvented and shaped as a standardized tool like an Index. Volume index would not only help reveal the changes in volumes but also facilitate a long term continued study of market liquidity. The formation of such indices world-wide would also indicate the global fund flow process. Hence, the need of the hour is a volume based index in all the markets of the world to complement the analysis of stock market and facilitate analysts and investors to get a holistic view of the markets. Introduction Stock market plays an important role as a financial intermediary in an economy. It facilitates the flow of funds from investors to entrepreneurs. Efficiency of the market depends upon various factors such as volume of trading, number of participants(Barnes, 1986) and flow of information. Trading volume indicates the state of the economy (Schneider, 2009) and it is higher in developed markets than in emerging and frontier markets. Thin volume of trading makes the interpretation of stock movement difficult for traders. Beaver (1968) mentioned that trading volume gives rough insight about earnings of a company and its impact on market participants. Trading volume not only measures the liquidity of stock markets but also the impact of information and momentum of the market (Brown et al. 2009). It is also influenced by corporate announcements / financial disclosures earlier than the price (Cready & Hurt 2002). Now, though investors generally have same public information, they infer it 103 THE NEED AND IMPORTANCE OF A VOLUME BASED INDEX differently which leads to trading activity in the stock market (Haris & Raviv 1993). The changes in trading volume reflect changes in the expectation of individual investors (Brown et al. 2009). May (2011) has translated the work of Bacheiler (1900) and stated that the relationship between price fluctuation in stock market and investor disagreement and trading volume was a matter of concern even 100 years ago. Almost after 80 years of Bacheiler; Ross (1989) identified the need of a model to study the investors’ disagreement and trading volume. Since then, a number of studies have been conducted to study the relationship between price and volume. Amongst all, the most important study was conducted by Wang (1994) where he stated that trading volumes is a dynamic variable reflecting behavioural heterogeneity of the traders and can be used as an important tool to study behaviour of asset price. Volume studies are important in determining the asset returns and have a positive relation with the magnitude of the price change in the equity market (Karpoff 1987). In contrast Bhagat & Bhartiya (1996) identified an asymmetric relation between price and volume. Moreover, Wang (1994) stated that volatility in volume depends upon the information flow in the market. Similarly, Gervais et al. (2001) identified that stocks whose trading volume is high have a higher probability of generating positive return in subsequent periods. Volume not only reflects the depth of market but also acts as confidence proxy for the market. Literature Review Investors and technical analysts use volume as an indicator to predict the movement of the stock. Blume et al. (1994) stated that volume and price change have positive relationship which helps technical analysts in decision making. There are a number of volume indicators used by technical analysts such as on-balance volume (OBV), money flow index, Accumulation / Distribution Line and Chaikin Money Flow. Thorp (2001) stated that on- balance volume (OBV) indicator was propounded by Joseph Granville in year 1963. The indicator considers todays and previous day’s closing price and cumulative volume of today’s and previous days. This indicator can be used to study the pattern of volume on a daily basis. However, it does not assist investors to study the pattern of volume on intraday basis. According to National Stock Exchange of India Limited (2010) accumulation/ distribution (AD) indicators considers the high, low and closing price of the shares and volume of the corresponding days to study the pattern. Chaikin Money Flow is the extended version of the accumulation/ distribution indicator, it considers the accumulation/ distribution values for 21 days period. Similarly, Money flow index (MFI) also considers the high, low and close price of the shares and volume of the corresponding period to determine the index. The index assists investors to infer the degree of the demand of the stock (Granville 1976). However, all of the above mentioned indicators assist investors to study the pattern of stock, they are not made to study the pattern of volume of market and also these indicators do not help in analysing the pattern of volume on intraday basis. According to Bessembinder & Seguin (1993) there are many empirical analyses which suggest positive relationship between price, volume and volatility of tradable asset. In addition to this, Chen et al. (2001) examined nine different national markets and concluded that volume consist some information about return of the stock. Blume (1994) also mentioned that past returns and past volumes indicate the expected pattern of stock market. Moreover to this, Kamath et al. (1996) stated that changes in price and volume have positive relationship, i.e. if price increases volume would also increase and vice versa. Other than concomitant relationship between trading volume and returns of stock, the dynamic relationship of volume 104 ACRN Journal of Finance and Risk Perspectives Vol. 3, Issue 3, November 2014, p. 103 – 122 ISSN 2305-7394 is also observed in various literatures (Blume et al. 1994, Wang 1994, and Chordia & Swaminathan 2000). Till today, most of the studies have been conducted revolving the price and volume relationship. Therefore, the price/ return indices world-wide have served the purpose for studying the direction of the asset values, leading to study of growth of an economy. As it has already been proven by past studies that price/ return alone cannot be a true reflector of growth unless studied with other variables like volumes. Ross (1989) has also mentioned the need of a standardized tool to study the significance and pattern of volume in stock market. However, still there is no benchmark/ indices which can study the pattern of volume of the market. In this paper, we propose to create a volume index, linked to the broad market price index of a country (India); with base year either matched to the base year of the price index or any other more appropriate year as the case may be. The propose index will help investors to study the pattern of the volume and price of the stock market. It will also help to determine the efficiency of the stock market. The target segment of this research paper is stock exchanges, trading members, investment management firms, researchers who study the behaviour and efficiency of the market. It may also be used by regulatory authorities to get some insight from the index, while designing policies, regulations and even invigilation activities for the stock market. The pattern of the stock market studies through the price, volume and volatility. Investors and academicians use these three key components to invest in the stock market and study the efficiency of the stock market. There are number of benchmarks and indices based on price and volatility such as S&P 500, Nifty and VIX to assist investors and academicians to study the pattern of the stock market. However, there is no benchmark to study the pattern of volume of the stock market. Index A market index is a combination of stocks representing the various industries/ industry or other investment vehicle together. According to Chakrapani et al. (2011), index is a statistical method to measure the change in economy or stock market. The market index presents the total value of those represented stocks as against the value of base year. Similarly Securities Exchange Commission (2014) has stated: "A market index tracks the performance of a specific "basket" of stocks considered to represent a particular market or sector of the U.S. stock market or the economy." In addition to SEC, Shilling (1998) wrote a book title "International Guide to Securities Market Indices" which is well known for the index study. He mentioned in the book that index is a barometer of movement and direction of prices of various financial instruments such as stock, money market instruments, real estate etc. Index is derived from the calculation, which is calculated according to their simple or composite structure against the base value of the underlying determined at the inception of index and the index moves continuously according to movements in the underlying.