On balance volume (OBV) is a momentum indicator that tracks the change in volume to price. On balance volume tracks the buying & selling pressure.
What is On Balance Volume (OBV)?
On-Balance Volume is a technical trading indicator that makes use of positive and negative volume flow to make predictions on the possible changes in a stock’s price trend. The concept behind On-Balance Volume was first developed by Joe Granville in 1963.
The main principle behind OBV is that during an uptrend in the market prices, the volume will rise along with the rising price, and in a downtrend, the volume will rise along with the price drop.
According to OBV, a sharp increase in volume without a significant change in the stock’s price is indicative of an upcoming increase or decrease in the stock’s price. A rise in OBV is indicative of a positive volume pressure which could lead to higher prices.
Alternatively, a decrease in OBV reflects a negative volume pressure which in turn may signify a drop in prices.
The cumulative total of the positive and negative volume flow forms the OBV line. By combining the direction of price with the relative volume of trades, the OBV line can give its users a sense of the strength of the trend at that moment. It can tell us about the likelihood of a trend continuing in the same direction.
OBV also brings out the relationship between crowd sentiment and price fluctuations.
OBV in charts
The chart above shows how the OBV line rises and falls corresponding to the variations in the price chart. The line can be seen to make highs with an increase in price and it can be seen to be declining when the price falls. The black or green bars correspond to the up-volume days when the closing price is higher than that of the previous days. Corresponding to these we can see a rise in the OBV line. The red bars on the chart mark the down-volume days when the closing price was less than that of the previous days; corresponding to which a fall in the OBV can be seen.
The Formula for OBV
The OBV line is a cumulative total of both positive and negative volume. A period’s volume is positive if the closing price is higher than the previous day’s and a period’s volume is negative when the closing price is lower than the previous day’s.
OBV is calculated depending on three case scenarios.
1. If today’s closing price is more than yesterday’s closing price, then the current OBV is calculated by adding the previous OBV to today’s volume:
Current OBV = Previous OBV + Today’s volume
2. If today’s closing price is less than yesterday’s closing price, then the current OBV is calculated by subtracting today’s volume from the previous OBV:
Current OBV = Previous OBV – Today’s volume
3. If today’s closing price is the same as yesterday’s closing price, then Current OBV is the same as yesterday’s OBV:
Current OBV = Previous OBV.
What Does On-Balance Volume Tell You?
Analysts and traders use OBV to identify or predict the major trends and trend reversals in the market. Using OBV traders can look for divergences between OBV and prices to predict possible near-term changes in the stock’s price. A change in the direction of the OBV can foreshadow a potential reversal in the price direction.
For example, when traders start to invest heavily in a particular asset, the volume of trades goes up. This causes the OBV to climb up which drives the price higher. If the volume however stopped climbing, within a particular trend, then that can imply that the buying pressure on a particular asset has started to decline and that the bullish trend is no longer rising in a sustainable manner. Similarly, the OBV line can also be applied to bearish trends.
In this image here, we see that the OBV line is rising, driving the prices higher and consequently developing a bullish trend.
The graph here shows us how a declining OBV line can be used to identify a bearish trend. From this graph we can infer the strength of the bearish trend and the high possibility of this trend continuing.
The actual individual quantitative value of OBV is not given much relevance as it is a cumulative indicator. By giving importance to the slope of the OBV line, analysts and traders monitor the nature of the OBV movements. They use OBV to keep track of large institutional investors and smart money.
The divergences between the price and the OBV line is one of the main aspects of the OBV that traders and analysts focus on. A divergence is formed when the OBV line and the price line move in opposite directions.
The chart here depicts a divergence in the price and OBV lines. Both the OBV line and the price line can be seen to be moving in two opposite directions.
When the OBV line shows a divergence from the price movement, it can imply that a price reversal is imminent. For example, if the price is climbing, but the OBV starts to drop, it can indicate that the buying pressure on the asset has started to decline, showing that a good selling opportunity may exist here.
Analysts and traders use the divergences to showcase the possible results of buying against the incorrect prevailing trends in the market. For instance, smart money may drive stock prices up, but once the retail investors start buying into the stock, the institutional investors may start to sell. OBV can also be used to identify or confirm price trends and trend reversal to find trading opportunities.
Non-confirmation of uptrend
The main principle behind OBV is that volume rises along with an increase or decrease in price. During an uptrend, OBV rises in the direction of the price. In this case, the price chart and the OBV chart will look identical, and the volume is said to be supporting the price increase.
However, when a non-confirmation of uptrend occurs the price and the OBV line fail to correspond to each other. Here, the price will continue to rise and make a higher top, but the OBV line fails to make a higher top. This means that although the price is increasing, the relative volume of trades is not supporting this price increase. Such a non-confirmation is generally seen at the end of an uptrend.
Non-confirmation of downtrend
Generally during a downtrend, OBV makes a lower top and lower bottom in a similar fashion as the price, thereby confirming that volume supports the downtrend.
However, in the case of a non-confirmation of a downtrend, the volume and price will stop moving in the same direction, that is, the price may break the last bottom but the volume may not.
This implies that the price has decreased with lesser volume thereby showing that the volume no longer supports the fall in price. This type of non-confirmation is generally seen at the end of a downtrend.
Advanced breakout
An advanced breakout occurs at the time when the increasing price reaches a point where it could not breach the previous top, while the OBV line on the other hand breaches the previous top. This is what is called an advanced breakout. It indicates that although the price has gone up, the relative volume of trades is so high that OBV makes an advanced breakout.
This can be seen as an indicator that the price will climb up further and breach the previous top. An advanced breakout, contrary to a non-confirmation, is considered to be a sign of strength.
Advanced breakdown
Generally in a downtrend, the price is expected to decline along with the volume, with both making lower tops and lower bottoms.
However, in the case of an advanced breakdown, the price will fail to breach the prior bottom, whereas volume will breach the previous bottom.
This is called an advanced breakdown. An advanced breakdown is suggestive that the price will decline further and breach the previous bottom, and is seen as a sign of weakness with respect to the price.
Advantages of on-balance volume
The OBV trading indicator functions as an indicator of momentum that shows the buying and selling pressure on a particular stock. When monitored, the OBV can make predictions on the trade direction as well as the near-term changes in price. It is useful in assessing the stock market sentiment, which can predict bullish or bearish outcomes.
OBV can predict major highs and lows and can be particularly useful in measuring the breakout and breakout potential.
Limitations of on-balance volume
As the OBV calculates the volume on a cumulative basis, the real number value depends arbitrarily on the chosen starting point. This makes the individual quantitative value of OBV less relevant, making it an unsuitable indicator for day traders.
Another limitation of the OBV is that it can be a little hard to identify divergences using this indicator and therefore it can’t be used effectively alone. Another possible drawback of OBV is that it doesn’t tell much about the asset as such.
Conclusion
OBV is an indicator that works on the principle that volume follows price. By using cumulative volume, it measures the buying and selling pressure. The buying pressure is visible when the OBV line rises and the selling pressure can be seen when the OBV line falls. Analysts and traders can use this indicator to predict or confirm market trends or look out for possible divergences that could bring on a change in the stock’s price.
OBV is a cumulative technical trading indicator and must be used ideally in conjunction with other technical indicators to include all aspects of technical analysis. Traders who wish to follow trends, generally use OBV signals along with other indicators that help to identify the trend. Those traders and analysts who wish to identify turning points in the market prices combine OBV with price reversal indicators.
