Explaining the causality between trading volume and stock returns: What drives its cross-quantile patterns?

This study investigates the impact of trading volume on future stock returns, addressing the gap in the literature as to why such causality has previously been found to be of varying signs and magnitudes. Using data from the US covering the period 10/1973-12/2018, we employ quantile regressions to empirically examine if the volume-return causality is driven by informed trading, investors’ liquidity needs, sentiment, or uncertainty. Our analysis reveals that sentiment and the prevalence of informed trading, especially on good news, significantly explain the observed cross-quantile volume-return causality pattern. These findings offer new insights into how stock trading, driven by irrational sentiment and following informed investors, causes temporary imbalances and future price reversals, highlighting the importance of investor irrationality, insider trading, but also illiquidity and imperfect arbitrage, for asset price behaviour. Our results provide implications for risk management, return and volatility forecasting, and regulation of insider trading and information provision.