If you have
read any of my articles on indicators, you know by now that I point out over
and over again that you should not take any trading decisions on indicators
alone. It’s in the name; indicators indicate. That is all they do. So far, I
have written about indicators that is calculated on price only; the simple and
exponential moving averages, the RSI and the MACD. But volume is a very
important variable in trading which these indicators ignore.
There are
several indicators that take volume into account and the On Balance Volume, or
OBV, is one of them. It was invented by Joseph Grenville and introduced to the
public in this book "Granville's New Key to Stock Market Profits" in
1963. He had the idea that volume precedes price movement and by tracking
cumulative volume it would be possible to anticipate a change in price.
Volume is definitely
important to traders, but can it really predict the future? In this article I
will show you how to calculate the OBV and how to interpret it and of course,
give you my personal opinion. At the end of the article you will find links to
additional sources on the OBV.
What is On Balance Volume (OBV)?
It is a
momentum indicator that uses volume flow to predict changes in stock prices. It
is based on the idea that volume is a leading indicator of price movement. By
observing the direction and magnitude of volume flow, traders can get a hint of
the strength or weakness of a price trend.
In short,
the OBV measures the volume of days the market goes and when the market goes
down and compares the two. OBV is then graphed as a single line, usually below
the price chart.
How to Calculate the OBV
The
calculation of OBV is straightforward. You simply add up the volume on days
when the closing price increases and subtracting the volume on days when the
closing price decreases.
If today's
closing price is higher than yesterday's closing price, today's OBV =
Yesterday's OBV + Today's Volume.
If today's
closing price is lower than yesterday's closing price, today's OBV =
Yesterday's OBV - Today's Volume.
If today's
closing price is equal to yesterday's closing price, today's OBV remains
unchanged from yesterday's OBV.
OBV is a
cumulative measure, meaning it builds on previous values, giving a running
total that reflects the net buying or selling pressure over time.
Just like
some other indicators, like the Exponential Moving Averages, we need a value of
OBV to calculate the OBV. For the first calculation we don’t have that value.
We need a starting point and that is normally set to zero. Here is an example
of the calculation of OBV:
Interpretation of OBV
OBV is used
to confirm trends and find divergencies. When both price and the OBV are making
higher highs and higher lows, the stock is considered to be in a solid uptrend.
When they are both making lower lows and lower highs, the downtrend is
confirmed.
When they
go in different directions there is a divergence. If price goes up but the OBV
is starting to go down, there is a negative divergence and we should be alert
that a change in the price trend is possible. And of course, if the roles are
reversed and we have a positive divergence, that is, price goes down, but the
OBV starts to go up then we have a positive divergence.
In my
opinion, a divergence in the OBV doesn’t have to mean that OBV and price goes
in opposite direction. Price can continue up while OBV goes flat is an indication
that volume isn’t increasing and below you will find a example of that in
Apple.
It can also
be used to confirm breakouts. When the price breaks out of a resistance level,
an increasing OBV can confirm the breakout, indicating strong buying pressure. If
the price breaks down below a support level, a decreasing OBV can confirm the
breakdown, indicating strong selling pressure.
The idea
behind this is that volume precedes price. A significant movement in OBV
without a corresponding move in price could indicate that a price change is
imminent. That makes sense to me since increasing volume is more or less
necessary for a stock to go up. But as with any indicator that is designed to
find divergencies; a divergence can exist for a long time before there is and
actual change in trend.
OBV wasn’t
the first indicator to take volume into account. The Accumulation/Distribution
Line (A/D) is older and Charles Dow, the founder of Dow Theory, believes that
volume was very important in confirming price trends but never developed an
indicator. But the OBV was the first indicator to be available to the public. Before
OBV, volume analysis was largely subjective. Granville’s work brought a
scientific approach to volume analysis which has been built upon, and today we have
other indicators that take volume into account. More about them in later
articles.
Limitations of OBV
The
advantage of OBV is obvious; it takes the very important volume into account.
But that doesn’t mean that it is the holy grail (there isn’t one in case you
were wondering).
Like any
technical indicator, OBV can generate false signals, for instance, during
periods of low volume. It is also sensitive to volume spikes. If there is a day
of extremely high volume due to some unforeseen event it has a big impact on
the calculation but might not have anything to do with the strength of the
trend itself.
Also like
many indicators, during time of consolidation in a sideway trading range, the
usefulness of the OBV is limited at best.
Use of OBV in Practice
To
illustrate the practical application of OBV, let’s examine a few real-world
examples:
Advanced
Micro Devices (AMD)
AMD started
a nice rally in November 2023 that continued in to March 2024 and price went up
about 145% from bottom to top. As we can se from the chart, the top in OBV set
in late January when the stock went into a short consolidation. When the stock
made new highs in March, the OBV did not and that was a very clear negative divergence.
Apple (AAPL)
In late 2020, Apple’s stock price was rising
steadily. However, towards the end of the year, OBV began to diverge negatively
from the price, signalling that the buying pressure was waning. Subsequently,
the stock price corrected in early 2021, validating the OBV signal.
Snap (Snap)
In late
September 2023 price bottomed out while the OBV had already started to rise
from late August. Later in the year price started to go sideways while the OBV
declined before price made a huge down gap in February.
Advanced Uses of OBV
A volume indicator like OBV is commonly used
together with another indicator as part of finding good trading setups.
A great example of this is to combine OBV with
Bollinger Bands. This can help in identifying overbought or oversold
conditions. If OBV reaches the upper band, it could indicate that the stock is
overbought and a short term correction might be in the cards. If OBV reaches
the lower band, it could indicate that the stock is oversold and a we should
look for a possible rebound.
Since OBV is not an oscillator (meaning that is
oscillates between fixed high and low values), it cannot find overbought and
oversold conditions on its own, like for example the RSI which oscillates
between 0 and 100.
Another way is to combine OBV with moving
averages. Plotting a moving average on OBV can help smooth out the data and
provide clearer signals, but the signals will be slower. A crossover of OBV
above its moving average can signal a buying opportunity, while a crossover
below can signal a selling opportunity.
Final Thoughts
Volume is an extremely important variable in
trading. In fact, volume is an indicator of itself. It takes volume to move the
market (upwards anyway). If there are more buyers coming into the market they
push the price up. It is a simple matter of supply and demand. If there are
more buyers than sellers, then prices will go up and if there are more sellers
than buyers then prices will fall.
To have an indicator that helps us identify
volume in a meaningful way, is a very useful tool for a trader to have in his or
her toolbox. The OBV tracks volume over time and is good at confirming trends
and indicate possible changes in trend.
The problem I have with OBV is that it treats
all price action equally. Volume is added or subtracted in the calculation no
matter what the trading day looked like. But that is not very accurate in my
opinion (and many other’s opinions to) since a day with a close at the high, or
very close to the high is more bullish than with a close near the lows, even if
they are both closing higher than the previous day. The OBV treats them equally.
In this example both days are treated equally
by the OBV but they are clearly very different in nature.
Also, I don’t think that OBV give that many signals in the form of divergencies, and they can also be very weak. In the cases above the divergences on the OBV line is fairy flat. Adding a moving average to the OBV may cut out some noise but it will also make the divergences even more difficult to see. On the MACD indicator the divergencies are much more obvious.
As always, don’t just take my word for granted.
These are my thoughts and experiences with the OBV. Others might disagree. Here
are some other resources you might find interesting. I can especially recommend
the video from the Darwinex YouTube channel. There are plenty of great videos
on this channel so it is worth checking out.
Worth pointing out that I may not agree with
the sources below 100%. For example, the Investopedia article states that the
OBV is a leading indicator since it predicts the future. I totally disagree
with this and you can read about that in this article.
On-Balance Volume (OBV): Definition, Formula, and Uses As Indicator - Investopedia
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