Name the confounder: trading volume and volatility

Question

Across trading days, a stock's daily trading volume and its daily volatility (size of the price move) are strongly positively correlated. A junior trader concludes: "Trading activity causes price swings, so if we throttle volume we can calm the stock down."

What third variable most plausibly drives both volume and volatility, making the causal claim suspect? Name it and explain.

Accepted Answer

The confounder is the rate of information (news) arriving. On days when a lot of new, price-relevant information hits the market (earnings, macro releases, sector news, informed order flow), traders reassess and trade heavily, so volume is high, and the new information moves the price, so volatility is high. On quiet news days, both are low. Information is a common cause sitting behind both variables; this is the mixture-of-distributions idea. Why the trader is wrong. Volume is not manufacturing the price moves; both respond to the same underlying information flow. Throttling your own partici…

Name the confounder: trading volume and volatility

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