The Role of Trading Volume in the "Volatility Puzzle

Abstract

We find that the negative average-return differential between high- and low-volatility stocksthe so-called volatility puzzleis particularly more pronounced when both groups of stocks have large trading volume. Conversely, the return differential is completely absent among low-turnover stocks. Such a high turnover-conditional volatility-future return relation is long-lived and present in various segments of the market and in different time-periodse.g., in both small and large stocks and during low- as well as high-investor sentiment periods. While the information contents of large trading volume are likely to be multi-dimensionalthereby allowing for different explanations, our results at least suggest that trading volume is a useful empirical guide to where to (not) find the average return differential between low- and high-volatility stocks. We also illustrate, in a setting that is neutral about market efficiency, how trading volume interacts with volatility and affects future returns.