Introduction
On-Balance Volume (OBV) is a technical tool utilized by traders to evaluate the volume flow of a financial asset, and make predictions about its future price movements. The concept behind OBV is that the volume of trading is a vital element in determining the direction of asset prices. OBV traces the cumulative volume of buying and selling pressure, and demonstrates whether this volume is rising or falling over time.
OBV was originally created by Joseph Granville in the 1960s, and introduced in his book “Granville’s New Key to Stock Market Profits”. Granville, a well-known stock market analyst, was convinced that OBV could detect major price changes by spotting when the volume changes dramatically without a corresponding shift in price. Additionally, he believed that OBV could reveal the behavior of institutional investors, also known as smart money, who frequently buy or sell large amounts of an asset before the price moves significantly. Granville referred to this behavior as “a spring being wound tightly,” anticipating that once the spring was released, the price would surge either upward or downward.
Apart from OBV, Granville was also recognized for his contributions to other technical indicators, such as “Granville’s New Key” and “Granville’s 8 Rules“.
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How does OBV work?
On-Balance Volume (OBV) is a popular technical indicator that helps traders predict changes in price movements of a financial asset by measuring the volume flow. Developed by Joseph Granville in the 1960s, OBV tracks the cumulative volume of buying and selling pressure to determine whether it’s increasing or decreasing over time. Granville believed that OBV could detect major price changes by identifying when volume changes sharply without a corresponding change in price, as well as reveal the intentions of institutional investors who tend to buy or sell large amounts of an asset before the price moves significantly.
The OBV formula is simple: the volume of each trading day is added or subtracted to a running total, depending on whether the price closes higher or lower than the previous day.
The formula for OBV is:
OBV = Previous OBV + Current Volume if Price closes higher than previous day
OBV = Previous OBV – Current Volume if Price closes lower than previous day
OBV = Previous OBV if Price closes equal to previous day
If the closing price is unchanged, the volume is considered neutral and has no effect on the OBV value. When OBV and price are moving in the same direction, it confirms the strength of the trend, while moving in opposite directions indicates a divergence that may signal a trend reversal. Generally, increasing OBV values can be seen as a bullish signal, while decreasing OBV values can be seen as a bearish signal.
The idea behind OBV is that changes in volume often precede changes in price, and tracking the cumulative volume can indicate the strength of a trend or a potential reversal. For example, if the price of an asset is rising, but OBV is falling, it means that buyers are losing interest or sellers are gaining control, which could be a sign that the uptrend is losing momentum and may soon reverse. Conversely, if the price of an asset is falling, but OBV is rising, it means that sellers are losing interest or buyers are gaining control, which could be a sign that the downtrend is losing momentum and may soon reverse.
How to use the On-Balance Volume in trading?
Trading with the On-Balance Volume (OBV) indicator can be done by itself or combined with other technical analysis tools like trendlines, moving averages, support and resistance levels, and oscillators. OBV can serve as a confirmation, divergence, or breakout tool. Below are some ways traders commonly use OBV:
Get familiar with the basics
The OBV indicator operates under the premise that volume leads price movement. The idea is that when volume increases, price is likely to follow in the same direction, and when volume decreases, price will likely move in the opposite direction.
Confirm or challenge a price trend
The OBV can confirm price trends. When the OBV and price move together, it indicates that the trend is valid and likely to continue. When they diverge, it shows that the trend is weakening and may reverse. For instance, if the price of a security is increasing, and the OBV is trending upwards, this suggests a strong uptrend. Conversely, if the price is decreasing, and the OBV is trending downwards, this indicates a strong downtrend.
Identify breakouts or breakdowns
When the OBV breaks above or below a trendline or horizontal level, this indicates that volume is supporting a breakout or breakdown in price. This information can be used to enter or exit trades in anticipation of a significant price movement.
Spot accumulation or distribution phases
When the OBV moves sideways within a range, this indicates that volume is balanced between buyers and sellers. This could indicate that the market is consolidating, and traders are accumulating or distributing their positions before a major trend change.
Use OBV as a confirmation tool
OBV can confirm the existing trend of an asset by moving in the same direction as the price. For example, if the price is making higher highs and higher lows, and OBV is also making higher highs and higher lows, it confirms that the uptrend is strong and likely to continue. Conversely, if the price is making lower highs and lower lows, and OBV is also making lower highs and lower lows, it confirms that the downtrend is strong and likely to continue.
Use OBV as a divergence tool
OBV can alert traders to potential trend reversals by diverging from the price movement. For instance, if the price is making higher highs and higher lows, but OBV is making lower highs and lower lows, it indicates that buying pressure is weakening and the uptrend may soon end. Conversely, if the price is making lower highs and lower lows, but OBV is making higher highs and higher lows, it suggests that the selling pressure is weakening, and the downtrend may soon end.
Use OBV as a breakout tool
OBV can help traders identify breakout opportunities by leading or lagging the price movement. For instance, if OBV breaks above a resistance level before the price does, it suggests that there is strong buying pressure behind the move and that the price may follow suit. Conversely, if OBV breaks below a support level before the price does, it suggests that there is strong selling pressure behind the move and that the price may follow suit.
Use OBV in conjunction with other indicators
One useful indicator to pair with OBV is the moving average. Moving averages are trend-following indicators that smooth out price fluctuations and help identify the direction of the trend. When the OBV and the moving average are both pointing in the same direction, it can provide a strong signal to enter or exit a trade.
Another technical analysis indicator that can be paired with OBV is the relative strength index (RSI). RSI is a momentum indicator that measures the speed and change of price movements. When used in conjunction with OBV, traders can get a more complete picture of the market conditions and potential price movements.
It is important to note that using too many technical analysis indicators can lead to analysis paralysis and confusion, so it is best to choose a few indicators that complement each other and stick with them. Additionally, it is crucial to conduct backtesting to ensure the effectiveness of your chosen combination of indicators before using them in live trading.
By using OBV in conjunction with other technical analysis indicators, traders can increase their chances of making profitable trades and reduce their exposure to market risks. Remember to always incorporate risk management and fundamental analysis into your trading strategy for a comprehensive approach to trading.
Watch for volume spikes
Significant volume spikes can indicate a change in trend direction. If the OBV is moving higher and the volume increases significantly, it is a sign that the price is likely to follow in the same direction. Conversely, if the OBV is moving lower and the volume increases significantly, it is a sign that the price is likely to move in the opposite direction.
Keep in mind that technical analysis tools like OBV should only be used as part of a comprehensive trading strategy that includes risk management and fundamental analysis. It is also important to backtest any trading strategies before using them in live trading.
Advantages & Limitations of OBV
Here are some advantages and limitations of using the OBV in trading:
Advantages
- Easy to calculate and interpret, making it accessible for traders of all skill levels
- Applicable to any time frame and market, providing flexibility in its use
- Can provide early signals of trend changes by detecting volume divergences, which can give traders an edge in predicting market movements
- Enhances other technical indicators by adding a volume dimension, allowing traders to make more informed decisions
Limitations
- Only provides information about the strength, not the direction, of price movements
- False signals can occur when volume spikes due to news events or other factors, which can lead to losses for traders
- Lag behind price movements when volume is low or inconsistent, potentially causing traders to miss out on profitable opportunities
On-Balance Volume (OBV) is a versatile technical indicator that can enhance your trading strategy by adding a volume dimension to your analysis. OBV is easy to use, can be applied to any market or time frame, and can provide early signals of trend changes by detecting volume divergences. When used in conjunction with other indicators and risk management techniques, OBV can improve your chances of making profitable trades.
However, it’s important to remember that no technical indicator is foolproof and should only be used as part of a comprehensive trading strategy. OBV does not provide information about the direction of price movements, and can generate false signals in certain market conditions. It’s important to conduct thorough research and backtesting before using OBV or any other technical indicator in live trading.
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