On Balance Volume
The on-balance volume indicator (OBV) is one of the most well-known momentum indicators and was developed in 1963 by Joseph E. Granville whose new book ‘HOW TO READ THE STOCK MARKET’ outlines his entire OBV theory.
The OBV stresses the importance of volume and its relationship to the price and momentum of any given stock. Fundamentally, the On-Balance Volume indicator compares the positive and negative volume flows of a stock against its price over a time period.
The basic concept that Granville used to design his OBV indicator was that when a stock closed higher than its previous daily close, then all of the day’s volume was considered as up-volume.
Whereas, if a stock closed lower than the previous daily close then all of its day’s volume was considered down-volume. The cumulative total of the positive and negative volume flows then formed the OBV line as the following chart shows.
Granville’s studies indicated that changes in the direction of the On-Balance Volume indicator forecasted potential reversals in price direction. For instance, if the market started to heavily buy a stock then the increased volume would force the OBV line to climb which in turn would drag the price higher.
The OBV can also be used to detect new trends. For instance, if the OBV shows higher consecutive peaks and troughs then a bull channel is in session whereas if it indicates lower consecutive highs and lows then a bear channel is predominant.
As the OBV does not reflect any comparison between stocks, traders should instead concentrate on its trend. By doing so, trader can detect if the OBV indicator and commodity price are still trending or diverging.
Granville also explained that if volume was not rising anymore within a buying channel then this was indicative that buying pressure was starting to wane and that the probabilities were increasing that the bull trend was no longer sustainable. He made similar comments regarding bear channels.
To provide further confirmation that a trend may be weakening, Granville recommended using a 20 period moving average in conjunction with the OBV. As a result, OBV users could then observe such events more easily by noting any crossovers of the OBV line and its moving average.
In summary, the On Balance Volume indicator is regarded by the industry as one of the most simple and popular momentum indicators and is best used to detect any new trade opportunities in the following ways.
If the OBV shows a divergence from price movement then a possible price reversal is imminent. For instance, if price is rising but the OBV has begun to drop then a possible selling opportunity may exist.
If the price and OBV are both in the same trend movement and the OBV begins to breakout then this is again signs of a new trading opportunity. These events can best be confirmed by noting any crossovers of the OBV and its moving average.
For instance, if both price and the OBV are in a bear channel and the OBV starts breaking to the upside, then a buying opportunity may be beginning to form.