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.
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.