On Balance
Volume (OBV)
Introduction
According to the basic theory of
volume as developed by Charles Dow, volume should rise in the direction of the
trend which basically implies that during an uptrend, volume must rise together
along with the rising price and in a downtrend the volume must rise when the
price goes down. This rising volume confirms the quality of the trend. With the
passage of time, as more and more research came into the subject, the theory of
On Balance Volume (OBV) was developed.
On Balance Volume (OBV)
According to this theory, volume is correlated with the change in price.
On Balance Volume (OBV) actually measures buying and selling pressure on a
cumulative basis which subtracts volume on down days and add volume on up days.
On Balance Volume was developed by
Joe Granville and it is one of the first indicators to measure positive and
negative volume flow. People often use OBV to confirm price trend and also look
for divergence between price and OBV.
Calculation
If today’s closing price is higher than yesterday’s closing price, then
yesterday’s volume should be added to today’s volume and the total volume
should be called On Balance Volume (OBV) for today. If today’s closing price is
lower than yesterday’s, then yesterday’s volume should be subtracted from
today’s volume and the net total would be called as today’s OBV.
However, if today’s close is equal
to yesterday’s close, then yesterday’s volume should not be touched and
whatever OBV we had yesterday, it would remain unchanged for today.
We are not concerned with the
absolute figure of daily On Balance Volume, rather what we are concerned about
is overall direction of the OBV line. The OBV line is simply a running total of
positive and negative volume.
Trading rules
During an uptrend On Balance Volume will follow the price direction and
will keep on making higher top and higher bottom. Hence both charts i.e. price
chart and OBV chart will almost look identical. As long as both charts move in
the same fashion, trend is said to be perfectly up i.e. volume is supporting
the rise in price.
On the other hand, during a
downtrend, OBV should make lower top and lower bottom in the same style as
price and it confirms that volume is supporting the downtrend and it is
perfectly intact.
A time will come when price and
OBV will fail to respond to each other. It may take place in any of the
following form-
1. Non-confirmation of
uptrend
Here the price will make a new
higher top but On Balance Volume will fail to make new higher top. This is a
first sign of trouble in an uptrend. It shows that although price is rising and
making higher top but volume fails to maintain that. It indicates that rise in
price is not been supported by rise in volume. This is called a
non-confirmation and such type of non-confirmation do and can occur at the end
of an uptrend.
2. Non-confirmation of downtrend
During a downtrend, price
and volume both are expected to go down in a same fashion i.e. lower top and
lower bottom. At times we will find that volume and price both are not moving
in tandem i.e. price has broken the last bottom but volume could not break. It
shows that price has broken with the lesser volume. This is the point of
trouble for the downtrend because volume is no more supporting the price fall.
This is called non-confirmation. This type of confirmation occurs at the end of
bear market.
3. Advanced breakout
Another important and
interesting factor of On Balance Volume is advanced breakout. As price and
volume keeps on rising together, there seems to be no problem but a time will
come where we will see that price could not breach the previous top, but OBV
line has breached the previous top. This is called advanced breakout. It shows
that although price has gone up marginally but volume generation is so high
that OBV has made an advanced breakout. This is the signal which tells us that
price will also cross the previous top. In fact a non-confirmation is a matter
of weakness whereas advanced breakout is a matter of strength.
4. Advanced breakdown
In a downtrend, price and On Balance Volume, both
are expected to move in the same fashion where both will make lower top and
bottom. But at times price will fail to break the previous bottom whereas On
Balance Volume will break the previous bottom. This is called advanced breakdown.
An advanced breakdown indicates that price will also break the bottom. This is
a matter of weakness on the part of price.
Conclusion
When
On Balance Volume and price both follow the same direction, regardless of the
trend, we can draw a trend line in price as well as in volume to watch pattern
similarities. Moreover, OBV should always be used in the daily chart in
correlation with the closing chart.
To
make better trades, you may combine it other indicators like Stochastic for
better confirmation. Let’s take an example to understand it better. You may
confirm the advanced breakout with that of positive divergence of Stochastic,
to place your trade for the upside. On the other hand, you may combine negative
divergence with the non-confirmation, to bet on the downside price movement.
