Introduction
The amount of indicators that you’ll see within the stock market is insane. No matter what situation you want to see identified, you can be sure there’s an indicator out there for it.
However, a lot of those indicators tend to base their calculations around price, like high, low, open, or closing prices.
What’s interesting is that there are indicators out there that are centered around volume, and look at that to gauge market sentiments.
You have the Volume RSI, the Chaikin Money Flow, the Klinger Oscillator, and many more. But the one that we’ll be talking about here is the OBV, short for On-Balance Volume.
What is On-Balance Volume (OBV)?
So, what is on-balance volume even supposed to be? Well, it’s supposed to be this technical momentum indicator that can utilize volume to predict stock price changes.
But who created it, you might be wondering, or how old is it? To answer your query, it’s very old, like 1960s old, and Joseph Granville created it.
He first mentioned it in his book titled “Granville’s New Key to Stock Market Profits,” which was published in 1963, to be exact.
The Purpose of OBV
The view that Granville held when he made the OBV was that volume was a vital force underlying the stock markets, and so he made the OBV to project whenever significant moves within the markets would happen with volume alterations.
Think of those predictions as “a spring being wound tightly.” Yes, do think of it like that, especially since those are the exact words that Granville himself used within his book.
After all, it was his belief that whenever volume increased sharply without any substantial change within a stock’s price, the price would follow suit, either by jumping upward or falling downward.
So, if we were to sum up what the OBV can do, it’s that it could confirm trends, spot divergences, and anticipate when the prices are going to breakout.
How is OBV Calculated?
You must have had a fair idea of what OBV actually is now. But how is it even calculated? Well, that’s what we are looking at here.
On-balance volume offers the running total of any asset’s trading volume while indicating whether or not this volume has been flowing out or in of that asset, which could be any given currency pair or security.
Hence, imagine it as this cumulative sum of volume, both negative and positive included. You have three rules that are implemented whenever the OBV is being calculated. Let’s look at that below.
OBV Calculation Formula
If the closing price of today is greater than that of yesterday’s, then the formula would look something like this: Current OBV = Previous OBV + today’s volume.
The second rule is that if the closing price of today is lower than that of yesterday’s, then the formula would turn into: Current OBV = Previous OBV – today’s volume.
The third and final rule is that if both yesterday’s and today’s closing prices are equal, then the formula would reflect that with: Current OBV = Previous OBV
And there you go. Here’s how the OBV is typically calculated—not that you really need to know it since many websites already do it for you. But if you’re more of the curious type, then there’s no harm in knowing it.
Key Parameters of OBV
So, the key parameters based on what we said earlier would have to be both the volume and the price. But why the price?
Once again, that’s because of the underlying belief or theory here, which states that the relationship of volume with the price is supposed to have a major role in determining trends, among other things.
How to Use OBV in Trading
Let’s put the theory into practice and see how the OBV can be used in your trading goals, like when you can find out exit and entry points, and more. So, without further ado, here are some ways of trading with the OBV.
Trend Confirmation with OBV
Trend confirmation can be quite a rudimentary way to use the OBV. The first thing you should do here is to go to a chart that draws a trendline along an OBV path, and once you’ve found a good and reputable chart, then just use that to confirm your trends.
If that trend line is starting to go upward, then it could mean that you might want to place some buying positions due to the upward pressure.
But if that same line is starting to go downward, you might want to enter those selling positions, because delaying it won’t do with that downward pressure.
OBV Divergences
Earlier, we went over how OBV operates under the theory that the relationship of volume and price may be used as an instrument for predicting changes.
This is just where divergences can come into play. So, naturally, looking at both the OBV trendline and price movement can help you identify those divergences.
If you see a stock’s price moving upwards but the OBV line going downwards, then it might indicate a bearish divergence, with the eventuality of the price going down highly likely.
You might want to start selling those stocks when you see that. The bullish divergence is obviously the opposite and will function so, where the price falls but that trend line begins to rise. If that’s the case, then you should consider buying something.
OBV and Breakouts
You may even use the OBV as part of your breakout strategies. But first you must analyze the relationship between the OBV indicator and the asset’s price over time, as that’s very important. Why?
Because within breakouts, asset prices usually break through key support or resistance levels, indicating shifts within the balance of demand and supply.
You could also use the OBV indicator to either negate or confirm breakout signals by seeing if that indicator is also breaking through key resistance or support levels.
You, as a trader who’s implementing that OBV breakout strategy, should wait for confirmation signals, like trendline breaks, moving average breaks, and whatnot, before executing a position.
Other traders often look for OBV volume surges too, in efforts to verify whether there’s substantial selling or buying pressure behind assets, as those may help with verifying how strong those breakouts really are or even if they are actually breakouts.
OBV Strategies for Different Trading Styles
Are you a day trader, or do you prefer swing trading? Or is the long-term more suited to your liking? No matter what your style is, you can be sure that the OBV indicator can be used to complement that, which is exactly what we’ll be discussing here.
Day Trading with OBV
If your preferences lie more within day trading, then there’s quite a lot you can do with the OBV indicator. For starters, you could incorporate a shorter look-back period that could fit in more with your interests.
After that, you could make use of strategies centered around intraday reversals and short-term breakouts.
Swing Trading with OBV
For swing trading, having a more medium look-back period would be more fitting considering how traders who prefer this style tend to focus more on medium-to-long-term gains.
Strategies that could make better use of this style would definitely involve divergence and trend confirmations.
Long-Term Investing with OBV
But if your trading preferences are more long-term centric, naturally, your look-back period could reflect such tastes, and you may use the OBV for some nice long-term trend confirmations and accumulation and distribution strategies.
Advantages and Limitations of OBV
Take any stock trading indicator, and you’ll find limitations along with the benefits. If you understand both, then that’s basically the first step you’ve taken to master it.
Benefits of Using OBV
Well, first come the benefits. Using this indicator grants some top-notch volume-based analysis, which can present early signals and can even confirm trends and breakouts. In other words, you can really put this indicator to good use if you use it to its full potential.
Limitations of OBV
As for the downsides, you should know that it’s a lagging indicator, and because of that, the potential for false signals is really there should market conditions undergo sudden changes, like volume spikes. It’s due to this that it cannot give you direct buy or sell signals too.
Conclusion
On-balance volume, to summarize, is a technical indicator capable of measuring negative and positive volume flow while analyzing the trading direction.
It can be displayed as this single line providing insights pertaining to the intent of participants within the market, which investors may then use to identify entry and exit points.
But OBV lacks specificity when it comes to information provision regarding the financial asset, which may cause some misinterpretations. You could combat that by using it with other indicators.
What is the difference between OBV and volume?
On-balance volume just showcases the relationship between down and up volume flows over time, whereas regular volume just shows you how many shares were traded every day or any specific period.
Can OBV be used for all asset classes?
Theoretically speaking, it may be used, but obviously the efficacy would be largely dependent on price action. You can’t expect it to be of much use during flat markets.
How can OBV help in detecting reversals?
A change within the indicator line’s direction, which moves against the current price trend, could signal reversals.
What is a bullish divergence in OBV?
A bullish divergence may happen if price falls but the OBV trendline rises.
How can I avoid false signals with OBV?
You can always avoid false signals by using other indicators like the RSI or moving averages like the SMA, EMA, or whatnot.