Trading under pressure with on-balance volume

On-balance volume (OBV) is a momentum indicator. In general terms, its calculation relates volume to price change. Developed by Joe Granville in the early 1960s, OBV provides a running total of market volume and shows whether this volume is flowing into or out of a given commodity, bond or stock based on changes in the market’s price.

OBV attempts to detect when a financial instrument is being accumulated by a large number of buyers or sold by many sellers. It is based on the concept that volume is the driving force behind the market. Therefore, OBV is designed to project when major moves in the markets would occur by measuring the positive and negative volume flow. By analyzing OBV, traders may project when major moves in the markets will occur.

Often, OBV is described as an attempt to determine the actions of the “smart money” in the market. Smart money typically is used to refer to market participants who are either large, well-capitalized traders or commercial entities with a broad understanding of the underlying commodity or “inside” information on the market fundamentals.

While it’s impossible to say precisely whose positions are reflected in the OBV indicator, it’s reasonable to assume that it reflects the behavior of the majority of the positions in the market. If we accept that, then we can accept the premise that OBV provides a reliable gauge of future market bias.

Calculation

On-balance volume is calculated by adding the day’s volume to a cumulative total when the security or futures contract price closes up, and subtracting the day’s volume to that cumulative total when the price closes down.

  • If today’s close is greater than yesterday’s close then: OBV = Yesterday’s OBV + Today’s volume (considered up volume). Up volume occurs when a market finishes a day of trading at a level higher than its previous close, meaning that the trading volume for the day was more bullish than bearish.
  • If today’s close is less than yesterday’s close then: OBV = Yesterday’s OBV – Today’s Volume (considered down volume). Down volume occurs when a market finishes a day of trading at a level lower than its previous close, meaning that the trading volume for the day was more bearish than bullish.
  • If today’s close is equal to yesterday’s close then: OBV = Yesterday’s OBV. 

“Beans on balance” (below) shows the January 2014 soybean futures contract with both volume and the OBV indicator. You can see how the OBV indicator is affected by both the volume data as well as price changes.

Interpretation

On-balance volume is a running total of volume. It tells us whether trading activity is stronger on increases or decreases in price. When the security closes higher than the previous close, all of the day’s volume is considered up-volume. When the security closes lower than the previous close, all of the day’s volume is considered down-volume.

The basic assumption regarding OBV analysis is that OBV changes precede price changes. The theory is that the flow of the smart money can be seen by a rising OBV.

Here is a key aspect to evaluating OBV: The absolute value of it is not important. Traders should instead focus on period-to-period changes in and characteristics of the OBV line. First, define the trend for OBV. Second, determine if the current trend matches the trend for the underlying security. Third, look for potential support or resistance levels. Once broken, the trend for OBV will change, and these breaks can be used to generate signals.

Also notice that OBV is based on closing prices. Therefore, closing prices should be considered when looking for divergences or support and resistance breaks. This method of analyzing OBV is designed for trading short-term cycles. OBV is a day-to-day indicator, and investors must act quickly and decisively if they wish to profit from short-term OBV analysis.

Signal generation

Bullish divergence signals can be used to anticipate a trend reversal. These signals are grounded in the theory that volume changes precede price changes.

A bullish divergence forms when OBV moves higher or forms a higher low even as prices move lower. A bearish divergence forms when OBV moves lower or forms a lower low even as prices move higher. The divergence between OBV and price should alert a trader that a price reversal could be in the making.

As seen in “Forecasting crude” (below), weekly crude oil prices are making lower low from $93 to $92, but a closer look at OBV suggests a higher high formation, shown with the blue line, is signaling a bullish divergence. Subsequent to the bullish divergence, crude oil jumped almost $5 to $97 in the following week.

Bearish divergence also can occur. This is shown in “Intraday gold” (below). As seen in the 15-minute chart, although gold makes a higher high from $1,260-$1,265, OBV makes a lower low, registering bearish divergence. Once prices trade below $1,250, the bearish divergence is confirmed. Price subsequently corrects all the way down to $1,220.

OBV also helps to understand the accumulation and distribution pattern of prices and can be used to identify breakout and breakdowns in the near future. Rising OBV during a trading range indicates accumulation, which is bullish; falling OBV in a trading range indicates distribution, which is bearish. 

“Sweet sugar” (below) includes a daily chart of sugar along with OBV. Sugar is trading in a range of 16.70¢-17.90¢ for almost 20 trading sessions. However, OBV has been rising while prices are trading in range. As we can see, a bullish breakout soon happened, with sugar reaching a high of 20¢. 

OBV also is a good confirming trend indicator. Once a trend is established, it remains in force until it is broken. OBV can be used to confirm an existing price trend, an upside breakout or a downside break. “Gaining ground” (below) shows how the higher price trend for Apple coincided with a rising OBV, hence confirming to traders that strength was behind the market.

Simple works 

OBV is a simple technical indicator that uses volume and price to measure buying and selling pressure. Buying pressure is evident when positive volume exceeds negative volume, and the OBV line rises. Selling pressure is present when negative volume exceeds positive volume, and the OBV line falls.

Traders can use OBV to confirm the underlying trend or look for divergences that may foreshadow a price change. As with all indicators, it is important to use OBV in conjunction with other tools of technical analysis. OBV should not be used as a standalone indicator for signaling trade entries or exits. Good indicators to use in conjunction with OBV include pattern analysis and momentum oscillators.

Bramesh Bhandari writes at www.bramesh-techanalysis.com and provides online tutoring on technical analysis. He can be reached via email at bhandaribrahmesh@gmail.com.

About the Author

Bramesh Bhandari is a proficient stock trader at Indian stock market.He share his insight in Forex,Commodity and World Indices through his site http://www.brameshtechanalysis.com.