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    Karpoff - Volume & Volatility - JFQA - 1987 PDF

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    The Relation Between Price Changes and Trading Volume: A Survey Jonathan M. Karpoff The Journal of Financial and Quantitative Analysis, Vol. 22, No. 1 (Mar., 1987), 109-126, Stable URL: http://links jstor.org/sieisici=0022-1090% 28 198703%2922%3A 1%3C 109%3ATRBPCA%3E2,0,CO%3B2-1 The Journal of Financial and Quantitative Analysis is currently published by University of Washington School of Business Administration ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hhup:/www.jstor org/about/terms.html. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at hhup:/www jstor-org/journals/uwash. html Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission, JSTOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @ jstor.org. hupulwww jstor.org/ Tue Aug 9 13:49:22 2005 JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS VOL 22, NO. 1, MAACH 1987 The Relation between Price Changes and Trading Volume: A Survey Jonathan M. Karpoff* Abstract ‘This paper eviews previous and current research on the relation between price changes and trading volume in financial markets, and makes four contebutions, Fist two empiri- cal relations are established: volume is positively related to the magnitude of the price change and, in equity markets, to the price change per se. Second, previous theoretical research on the price-volume relation is summarized and critiqued, and major insights are emphasized. Third, a simple model ofthe price-volume relation is proposed that i eonsis- tent with several seemingly unrelated or contradictory observations. And fourth, several directions for future research are identified. |. Introduction ‘This paper is a review of empirical and theoretical research into the price- volume relation in financial markets.! There are at least four reasons why the price-volume relation is important. Fist, it provides insight into the structure of Financial markets. The models discussed below predict various price-volume re- lations that depend on the rate of information flow to the market, how the infor- ‘mation is disseminated, the extent to which market prices convey the informa tion, the size of the market, and the existence of short sales constraints. Empirical relations between prices and volume can help discriminate between differing hypotheses about market structure Second, the price-volume relation is important for event studies that use a combination of price and volume data from which to draw inferences.? If price ~The author would like to thank Linda Bamber, T. Wake Epps, Lary Haris, Alan Hess, Rob x Jennings, Avi Kamara, Geonge Tauchen, Ralph Walking, and the JFQA Managing Editor and anonymous referees for many helpful comments and suggestions. Finacial support was provided by the University of Washington's Cente forthe Sty of Banking and Financial Markets. "To keep this tsk manageable, the price-volume relation is narowly defined. A substantial ‘mount of empirical and theoretical work also relates othe costs of transacting in secures markt tnd the priceseting behavior of Noor specialists and dealers (see Cohen, Mater, Schwartz, and ‘Whitcomb 1979 fora survey, and also (27) (14, and (7). Epps (21) examines the effect of tan Action costs on volume. Volume has also been used io examin the existence of dividend cents CC}. [8p arbitrage around ex-ividend days (47, [32)), the effects of information uncertainty (4), and abirage activity 50] 2 Volume his been used to infer whether an event had informational conten" and whether investors interpretations ofthe information were similar or dtferet (51, 47]-[25 (5 and (2, [] ora erg, see (63). Hams and Gurel [37] use pice and vote the price pressure hypothesis. The dividend studies cited in note | are other examples, 109 110 Journal of Financial and Quanttative Analysis changes and volume are jointly determined, incorporating the price-volume rela- tion will increase the power of these tests. For example, Richardson, Sefeik, and ‘Thompson [58] examine trading volume and price changes to test for the exis- tence of dividend clienteles. In other tests, price changes are interpreted as the market evaluation of new information, while the corresponding volume is con- sidered an indication of the extent to which investors disagree about the meaning of the information.’ The construction of tests and validity of the inferences OF X = [x = x(Qp) | x'(Ap) > 0} Y = ty = yV) | ¥'W) > OF. Examples include w(Ap) = Ap? or (V) = InV. Empirical tests, have, in general, specified monotonic, linear relations between either weW and yeY of between xeX and yeY. (Exceptions include the nonparametric tests of Epps [20], ‘Smirlock and Starks [64], and Harris [35], (36}). But it is possible that volume (clements ofthe set Y) correlates positively with the elements of both sets W and X. To illustrate, consider Figure 1, in which it is assumed for simplicity that w(4p) = |Ap|, x(Ap) = Ap, (V) = V, and the expected volume is related line- arly othe price change (the solid line), but with a discontinuity at Ap = 0 such that the relation is nor monotonic. For positive price changes, the conditional expected volume-price relation is V+ = f(dp | Ap > 0); for negative price changes, it is V~ = g(Ap | Ap = 0). If f* > |g’| is assumed, then for any given expected level of volume E(V) = E(V +) = E(V~), ELV */Ap) > EV ~/|Ap)). ‘This would be consistent with the findings of Epps 20}, {22}, Hanna [33], Smir- lock and Starks [64], and Jain and Joh [38]. Similarly, a test for linear depen- ddence between V and Ap per se, although misspecified, would discover a positive conrelation. This is represented by the dashed line, and is consistent with the findings of Ying (items | and 2), Morgan [51], Rogalski (60), Harris [35], [36], Richardson, Sefeik, and Thompson [58], and Comiskey, Walkling, and Weeks [12}. The assumption that f’ > |¢’| also implies the relation between V and |Ap| is not @ one-one function, as demonstrated when the conditional expected volume ‘on negative price changes is plotted in the frst quadrant, V~ = hilAp | Ap <0). A test for linear dependence between V and |Ap|, also misspecified, would yield positive results, as data would be generated along the solid and dotted lines in the frst quadrant. Tis is consistent with mos of the findings listed in Table 1. How- ever, notice that both ofthe specified linear relations are wrong, so one would expect empirical tess that specify linear relations would yield statistically weak results. AS previously noted, tis is also consistent with several of the studies reported, and can account for the failure of a minority of researchers to uncover statistically significant volume-prie correlations. Karpott 121 ap FIGURE 1 Hustration ofan Asymmetric Vlume-Price Change Relation Call Figure 1 a representation of an “‘asymmetric volume-price change hy- pothesis,” indicating the relation is fundamentally different for positive and neg- ative price changes. It implies the following empirical propositions, each of ‘which is apparent from inspection of Figure 1 (1) The correlation between volume and positive price changes is postive. (2) The correlation between volume and negative price changes is negative. 3) Tests using data on volume and the absolute value of price changes will yield positive correlations and heteraskedastc error terms. (4) Tests using data on volume and price changes per se will yield positive correlations, When ranked by the price change, the residuals from a linear re _ression of volume on price changes will be autocorrelated. VI. Conclusions: Issues for Further Research It is likely that observations of simultaneous large volumes and large price changes—either positive or negative—can be traced to their common ties to in- formation flows (as in the sequential information arrival model), or their com- mon tiesto a directing process that can be interpreted as the flow of information (as in the mixture of distributions hypothesis). And the relatively large cost of taking a short position provides an explanation for the observation that, in equity ‘markets, the volume associated witha price increase generally exceeds that with ‘an equal price decrease, since costly short sales restrict some investors’ abilities to trade on new information, This summarizes much of what is known about the price-volume relation. We conclude by identifying several issues that merit fur- ther inquiry, (1) Is the price-volume relation asymmetric, as proposed in Part V? An asymmetric relation explains the two major empirical findings reported in this, survey, but it is not the only plausible explanation. Ying [72], Morgan [SI], Harris [35], [36], and Richardson, Sefcik, and Thompson [58] cach found both correlations in the same data set. This provides some support forthe hypothesis, of an asymmetric relation, but the somewhat anomalous findings of Wood, Melnish, and Ord (71] indicate thatthe asymmetry occurs in the opposite direc tion, (2) What would account for the asymmetric price-volume relation? If the 122 Journal of Financial and Quantitative Analysis key is short sale constraints, then futures market data would reveal no correlation between V and Ap, as reported in Karpoff [43]. To the extent organized option trading reduces the cost of taking net short positions, the asymmetry should be attenuated in price and volume data from optionable Securities. This proposition has not been tested.'5 (G) Does the size of the market affect the price-volume relation? This analy- sis suggests two possible effects of market size. First, in equity markets, heavily traded issues are more likely to be optionable in organized exchanges (see the preceding paragraph). The second possible effect is suggested by Tauchen and Pitts’ results, which predict thatthe covariance of volume and the squared price change increases with the number of investors, but t a decreasing rte (4) Do properties of the rate of information flow affect the price-volume relation’ All of the models discussed in this review use the notion that informa- tion, or something that is interpreted as information, drives the market to its suc cessive equilibria, Price-volume relations then arise because of assumptions about the nature of investors’ reactions. Inthe mixture of distributions models of Tauchen and Pitts (65] and Harris [34], the correlation of the squared daily price change and the daily volume increases with the variance ofthe daly rate of infor- ‘mation flow. This implies that this price-volume relation is strongest in markets ‘or at times in which the flow of information is most volatile. On the other hand, Pleiderer [56] argues thatthe strength ofthe relation increases as more trading ‘occurs for noninformational reasons. (5) Are the price-volume relations reported here identical over different fre- quencies? Tauchen and Pitts’ model implies that V and Ap are independent at the transaction level. Epps’ [20] model implies a positive correlation at the transac~ tion level, while the Epps and Epps’ and Jennings and Barry models imply a correlation between V and [Ap] atthe transaction level. Copeland's model implies this same correlation, but over the length of time necessary for each piece of information to reach all investors. The empirical work to date indicates that the ‘empirical correlation of V and |Ap| is stronger over fixed time intervals than over «fixed number of transactions ([35), (6). (6) Can the price-volume relation be exploited to improve event study stati tics? The models that hypothesize daily price changes are mixtures of distribu- tions that imply the conditional variance of the price change is proportional 10 volume. Volume, in turn, proxies for an entity that can be interpreted as informa- tion flow. Ifthe rate of information flow tends to be higher around “event” per ‘ds, then the variance of the “true” price process is higher around the event date, indicating that statistical tests of abnormal returns around the event should bbe done with a sample variance adjusted for the rate of information flow. With a Exactly how option trading should affect the prce-vlumeasymmety is not obvious. Ives: ‘ors with unfavorable information ean now buy pots or wie calle rather than el he tock sor. THis ‘would rer decrease stock trang volume over intervals with unfavorable information. However, *abirageurs woud sel the stock to mainam pull parity. inceaing the volume of tae. The net fect should bean increase in wading volume associated with unfavorable information, since the cost, ff trading on Such information i lowe. referee has pointed ou that whether option are traded ‘epends on characterises of the security that may alo alfet the corelation of price and volume, ‘©. the sz af the matket oe information flows (see points 3 and Blow). Ts 2 est for wheter the comlation between Vand Ap is stented in optonsble secures equ farther constraints 0

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