Unexplained Volume as a Critical Indicator

Researchers have recently focused on divergence of investor opinion as an indicator of future stock returns, but measuring this divergence using publicly available data has been problematic. In his April 2005 paper entitled “Measuring Investors’ Opinion Divergence”, Jon Garfinkel uses a non-public indicator of the stock valuations of investors to validate four public indicators: bid-ask spread, unexplained volume, forecast variability among analysts and stock return volatility. His non-public indicator is the standard deviation of the differences between all limit order prices and the most recent trade price, capturing actual investor price targets. Using data from 1995-1996 for the one non-public and four public indicators and focusing on activities before and after 150 selected NYSE trading halts, he concludes that:

• All four public indicators of investor opinion divergence correlate positively with the non-public indicator. However, the real explanatory power lies only in the bid-ask spread and unexplained volume. Other analyses suggest that unexplained volume is the best public indicator of investor opinion divergence.
• The bigger the news about a stock, the larger the divergence of investor opinion it produces.
• Investor opinion divergence is larger for small-capitalization stocks than for larger firms.
• Events which lead to increases in the earnings forecast variability of analysts also lead to declines in the opinion divergence of investors.

The author defines unexplained volume as volume after news events minus average (liquidity) volume during quiet pre-news control periods.

In summary, investors/traders should focus first on unexplained volume in a stock, and then on its bid-ask spread, as indicators of future abnormal returns.

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