Efficiency in trading comes from greater activity.
Many investors forget that one of the defining characteristics of the stock market is that it's a market. Buyers and sellers help determine the price of each stock, and the more buyers and sellers a particular stock has interested in it, the more liquid the market will be. Liquidity can have a profound impact on just how violently stock prices can move in either direction, and the reasons have to do with the nature of the market in a stock's shares.
Trading volume and economic fundamentals of share prices
As with many things, what determines a stock's price in the short run is supply and demand. Different investors make a variety of assessments of a company's future prospects and therefore assign values to stock that differ. When one investor is willing to buy shares at a price at which another is willing to sell, then both see an opportunity from a trade. By contrast, if everyone agrees that an appropriate stock price is significantly above the previous trade price, then the shares will rise in value quickly.
When a stock has a lot of investor interest, the greater number of different view on the stock's value creates more opportunities to trade. That typically shows up in the form of narrower spreads between the price buyers are willing to pay and the price sellers are willing to accept for shares. For instance, many actively traded stocks have spreads of just a single penny per share between the bid price from buyers and the ask price from sellers. Stocks that have relatively little trading volume can have spreads of a dime per share or more.
Why thinly traded stocks can take you for a bumpy ride
Most of the time, the impact of trading volume is relatively neutral. Because the spreads between bid and ask prices are wider with thinly traded stocks, their prices will tend to move in a kneejerk manner, compared to the smoother movements among stocks with higher trading volumes.
Where investors really see the difference, though, is when a company announces important news. With stocks with high trading volumes, you'll typically see a one-time jump or drop followed by relatively smooth trading thereafter, as the large number of investors following the stock can make rapid assessments of the impact of the new information. With less frequently traded stocks, however, the swings can be much greater, and the stock price can overshoot and reverse itself several times as a relatively small number of investors fight to agree on an appropriate new price for the shares.
Trading volume in itself doesn't affect stock price directly, but it does have a huge impact on the way that shares move. Investors who look at thinly traded stocks need to be aware of the heightened volatility involved before they buy.
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