Can Trading Volume Predict Realized Volatility?

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Realized volatility (RV) is a measure that captures the degree of price fluctuation in a financial instrument over a specific period. This metric is valuable for investors and traders as it reflects the true price action experienced by an asset, aiding in risk assessment and strategy development. Realized volatility contrasts with implied volatility, which is derived from option prices and represents market expectations.

There is a body of research literature that demonstrates a relationship between realized volatility (RV) and trading volume (VOL).  Reference [1] addresses the same research subject but employs different methods, including the Granger causality test, Mean Square Error, and Mean Average Error models. The author pointed out,

The aim of this study was to investigate the relationship between RV and VOL, to ascertain or rebuff the sequential information and the mixed distribution theories as well as the findings of prior literature using the most recent data. The results of this study reveals that there is no meaningful relationship between RV and VOL, hence they cannot be used as estimators to predict one another. Based on the findings of this study, sequential information and mixed distribution theories are irrelevant, at least in the current dispensation. The findings of this study also suggests that new information entering financial markets tend to be disseminated faster to active market participants probably due to regional and global integration. Also, financial market contagion which has increased recently may be a propelling factor for new information transmission. Since there is no relationship between RV and VOL, traders may need to rely on other indicators or factors to make trading decisions. They may need to adjust their strategies to incorporate different signals or factors that are more relevant for predicting market movements or identifying trading opportunities.

In short, contrary to the majority of research papers, the author demonstrates that there is no relationship between VOL and RV except for the CAC 40.

This result is surprising. It proves that the market is highly efficient.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Samuel Tabot Enow, Exploring the relation between realised volatility and trading volume: evidence from international stock market, Journal of Management and Entrepreneurship Research 4(2):82-90

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