Understanding the On Balance Volume Indicator
Swing traders are going to love this one…
The On Balance Volume (OBV) indicator was developed by Joe Granville in the 60s, and was designed to display the flow of volume in and out of a stock or index. Simply put, the OBV is a running tally of volume. The OBV can trend up (bullish), down (bearish) or sideways (neutral). An example with annotations is show below on $AAPL:
How On Balance Volume Works
A random number is used to begin an OBV line. As a result, the specific On Balance Volume reading on the right axis isn’t really that important, as the number can vary greatly, from near zero to something huge, and can be positive or negative. What matters is how the indicator is behaving, and its overall angle of movement. On Balance Volume’s primary use is a trend confirmation tool, but it’s also believed to predict price reversals, as significant changes in volume can be a signal of a major price change to come.
Joe explained his theory and development of his indicator by proclaiming that when/if volume decreased or increased dramatically with no substantial change in price, then eventually the price would jump north or south sharply. “A wise guy, huh?”
It makes plenty of sense. As institutions (trading houses, investment firms, etc.) start to buy into a stock which retail traders (little guys) are still selling, volume begins to increase as price action is still fading slightly and/or bottoming. This is the recipe for a pop to the north in price action. Next time you see a long fall or sharp pop that levels and out and trades sideways, pull up your On Balance Volume.
An example would be if a stock were to trade in a sideways channel for a number of days, yet it had a rising OBV line. Many traders would argue the scenario as highly bullish. According to Granville’s theory, the hidden demand will eventually become apparent and force prices in a spike higher.
When comparing the indicator to a price chart, the On Balance Volume is capable of several things:
- Confirms price action, by trending downward as the price falls, or upward as it rises
- Shows divergences from price – bullish or bearish
- Acts as a leading indicator, meaning if On Balance Volume makes a new high but price remains steady, price action may follow the indicator to new highs as well
Traders can also analyze OBV by using it in tandem with trend lines and moving averages. An example is shown on the weekly chart of $TSLA below. In this example, from December 2015 until February 2016, the stock was in a free fall, taking close to a 50% “trimming.” However, after falling more than $100 to the low 140’s, the trend line, 200 MA intersection, and OBV bullish divergence create a BTFD signal. The stock rallies in the coming months to recover the entire loss of the fall, and extend further.
Most people hear “divergence” and think RSI. A great tool it certainly is, but since On Balance Volume can be used as further confirmation of trends, it can also provide warning signals that a change in price direction is potentially nearing. A divergence is a warning sign, and happens when price creates a higher high, while the indicator is either flat, or dropping. Another example would be if price creates a lower low, yet the indicator is flat or moving upward. Simply put, the indicator should follow price. When it goes the other direction, it’s trying to tell you something.
A good example of using divergences as further confirmation of a further downtrend is shown below on the $NFLX daily chart. A rising wedge is visible with white trend lines, while a potential ascending broadening wedge from the monthly is visible in blue. The steady long term divergence on the OBV confirms both bearish patterns further. The point of most volume was near the beginning of the rising wedge, at a much lower price than the highs that followed, confirming an unsustainable rally on excessive speculation.
Here the play was to short the trend line break, coupled with the OBV bearish divergence. A stop loss could have been placed just north of the trend line, should a re-entry of the rising wedge occur. You could hold the trade for as long as the On Balance Volume confirms the stock is in a downtrend (by continuing lower.) In the $NFLX example, you can see the ideal exit was when the OBV line bottomed and made a higher high (which I have marked with the thin white line on the chart.) Price action bounces off of the demand line of ascending broadening wedge shown in blue.
If price action is trending downward, but the OBV is rising (bullish divergence), the entry signal is when price action break above its current downtrend line. A stop loss could be placed just below the recent low. You could hold the trade for as long as the On Balance Volume confirms the stock is trending upward. The exit signal would be if price breaks below its upward trend line.
As divergences demonstrate, On Balance Volume can act prior to price movement, which can render it very useful for indicating the direction of price breakouts. More examples of divergences shown below on $AAPL daily chart:
There has to be a Downside
Of course, with every situation there are pros and cons. OBV is no different. Indicator too good be to true you ask? Perhaps.
One issue with the OBV indicator is that it doesn’t handle spikes very well. An enormous, abnormal spike in volume can throw off the OBV for quite a while. Things like index rebalancings, an earnings beat or miss, or a block trade from an institution could all cause On Balance Volume to go straight up or straight down. This spike in volume could be relevant, or irrelevant to true price action.
Granville was convinced that flux in volume direction, displayed by On Balance Volume, will always happen before price action shifts and reverses direction. Ya… sorry, it isn’t that easy. On Balance Volume might assist in predicting many reversals, but it’s known to provide a lot of false signals as well.
Never rely on any one signal to enter or exit a trade. Look at the technical indicators that you know and use. When signals line up with one another, pay attention.
It should be reiterated that you should never rely on any one signal to enter or exit a trade. Couple up your most reliable indicators and tools to create a list of “evidence” to support your “case” of future price movement. Prove it to yourself. Why? Explain the trade.
This is a great tool to use on that “stand back and look at the big picture” chart for smaller time frame trades. More that in Trading Using Multiple Time Frames.
One thing to note, is that a lot technical analysis tools, like moving averages, are known as “lagging” indicators. They are known by this reference because they display changes in pattern after the fact. On Balance Volume is one of few tools that serves as a leading indicator, potentially forecasting changes in price action before they occur.
If you learned something, share with others within your trading community.