A new study identifies a positive link between high trading volume and the volatility of stock prices.

Ilia Dichev

The two phenomena have long been assumed to be connected, but the new study has found evidence of the impact. The research is scheduled to be presented next month at the annual meeting of the American Accounting Association in Denver by the three scholars who conducted the study. They found that sheer volume accounts for approximately 25 percent of share price volatility, and an even greater proportion at the highest trading volumes.

"We find repeated and economically substantial evidence that more intensive stock trading is accompanied by increased return volatility," reported the study's authors, Ilia D. Dichev and Dexin Zhou of Emory University and Kelly Huang of Georgia State University. "This relation is weak to non-existent at low to moderate levels of trading but becomes increasingly strong as volume of trading increases...The combined impression from these results is that high volumes of trading can be destabilizing, injecting a sizable layer of trading-induced volatility over and above the unavoidable fundamentals-based volatility."
The study’s authors suggested that one way to dampen volatility and discourage speculative excesses would be to impose taxes on trading.

While they don’t offer an opinion on whether a stock transaction should be enacted, one of the study’s authors noted that the past two decades have witnessed the most spectacular surge in stock-trading volume in history. Referring to a 1989 article co-authored by economist Lawrence Summers and his first wife Victoria before he became Treasury Secretary, in which he proposed a securities transaction tax, Dichev noted, "They argued in 1989 that a securities transaction tax would curb speculation and raise a significant amount of money. If that was true then, it would likely be all the more true today."

The new study probes the relationship between volume and volatility by using three natural experiments in which there is a substantial difference in the volume of shares traded without a significant difference in fundamental information about the companies involved -- 1) when stocks switch exchanges; 2) when stocks are added to or deleted from the S&P 500; and 3) in cases of dual-class stocks (for example, A-class shares that feature different voting rights from those of B-class shares).

In the first of these experiments, the professors analyzed 2,860 exchange switches that occurred between 1962 and 2009 and found that "change in volume produces a near monotonic ordering on change in volatility," results that are not only statistically significant but "economically substantial."

For example, among the nearly 1,000 switches between the New York Stock Exchange and the American Stock Exchange, the roughly 200 stocks that suffered the largest drops in volume were traded on average 44 percent less in the month following the switch than they were in the month before the switch, and their volatility (measured by the standard deviation of daily stock returns) declined by approximately 25 percent. In contrast, the 200 stocks whose volume rose the most following the switch (on average, about 112 percent) registered an increase in volatility of almost 14 percent.

In effect, the difference in volume change between these two groups was about 156 percent, and the difference in volatility, paralleling the volume change closely, was about 39 percent.

"If such magnitudes are anywhere close to a guide for what one can expect in more generalized settings, it is clear that the...30-fold increases in volume [since 1960] likely have a pronounced effect on observed stock volatility," according to the study. The results in the second natural experiment (addition to or deletion from the S&P 500) are "remarkably similar to those for exchange switches," and results for the third experiment (dual-class shares) are "largely consistent" with the other two.

The researchers then extended their examination by analyzing the trading volume and volatility of all NYSE-AMEX stocks over the 20-year period from 1988 to 2007. First they divided the sample into deciles on the basis of trading volume and found that, while volatility rose by more than 50 percent from the first to the tenth deciles, almost the entire rise occured where turnover was extremely high.

"There is little reliable variation in volatility from the first decile until about the seventh decile, followed by a quick rise and hitting a high in the top decile...in the extremes of high trading," they wrote.

Then the professors went a step further by controlling for companies' earnings variability, which, they found, accounts for about three times the amount of volatility that trading volume engenders. This, they noted, was hardly surprising, since “in an efficient market fundamental variability should be the only variable that affects stock volatility. What is more remarkable, actually, is that the effect of trading intensity remains economically large after controlling for fundamental variability... [so that it accounts] for about a quarter of total stock volatility.”

They conceded that “theoretically, there is a solid argument that higher investor participation and trading lead to better price discovery and therefore to prices that are closer to fundamental values,” but the study’s authors noted that “much of the previously documented benefits of liquidity come from environments with low trading intensity...In contrast, the evidence in this study comes almost exclusively from the largest, most-traded environments and stocks of all time.”

They noted that high volatility in trading tends to benefit just a small group of investors. “While the early gains from trading and liquidity are widespread, the benefits at very high levels of trading are much more specialized, accrue to a smaller circle of people, and lean in the direction of redistribution rather than the creation of new wealth,” the professors wrote. “While it is helpful to be able to buy and sell sizable investment positions promptly, the race to trade on slivers of new information a fraction of a second faster than anybody else is more questionable as a value-enhancing activity at the society level.”

The study, known as "The Dark Side of Trading," will be one of hundreds of scholarly presentations at the American Accounting Association's annual meeting. More than 3,000 scholars and practitioners are expected to attend the conference in Denver on August 5-10.