Relationship between Bid-Ask spread, Trading Volume and Return

Volatility

Before we can examine the relationship between the three concepts, it is important to define
them. The bid-ask spread is the difference between the maximum price buyers are willing to
pay for the shares of a company’s stock (Bid) and the minimum price that the sellers are
willing to sell the shares of a company’s stocks at (Ask). The Bid-ask spread is often used as
an important measure of the liquidity of a stock. The bid-ask spread is narrow when the
market is highly liquid and broad if the market is illiquid. Conventionally, volatility
(variability of returns) acts towards increasing the spread between the bid and the ask price.
Trading Volume refers to the total number of shares bought traded in a single day of trade in
the stock market. When stocks are purchased in large quantities, the price of these stocks
shoots up sharp, if these stocks are then sold in large quantities, the price plummets. An
imbalance between the buy and sell orders of a stock increases the volatility of return for the
stock. Most of the evidence suggests that return volatility and trading volume share a positive
relationship. This is due to the presence of asymmetric responses of volatility to changes in
the volume of trade.

However, a positive relationship doesn’t imply causation. If the trading volume is large but
there exists a balance between the buy and sell orders, the volatility for the stock remains
low. Stocks which are traded at low volumes may have higher volatilities than high-volume
stocks. This could be due to the illiquidity of the stock, which then results in major price
changes once the stock is traded. This is because a low number of illiquid stocks are traded.