On-balance volume: 3 (easy) ways to improve your trading using market volume

On-balance volume: 3 (easy) ways to improve your trading using market volume

The on-balance volume (OBV) is a volume-based trading indicator widely used in technical analysis. It simply identifies buying and selling pressure by analyzing market volume.

Every day, trillions of stocks and other financial instruments are traded by small retail traders and big institutional players.

What if you were able to track footprints of those giants moving the markets?

This is the main goal of OBV indicator.

Let’s now see what it is and how to use it.

What is on-balance volume (OBV) and what does it mean

Graphically, on-balance volume (OBV) appears as a simple line plotted at the bottom of a price chart:

The-OBV-indicator-in-US-stock-market-daily-chart-Google

OBV chart is a cumulative volume total. This means that on up-days volume is added to the total, while on down-days volume is subtracted.

So, OBV tracks on a simple line volume variations in the market.

The origins of OBV line

OBV indicator was firstly introduced in 1963 by Joe Granville in his book “Granville’s New Key To Stock Market Profits. Even though this paperwork is quite old, OBV technical indicator is still applicable in today’s markets.

The idea behind is very simple:

price should follow volume.

Whenever this does not happen, market shows a divergence and soon we can expect price to move according to volume action.

The interpretation of on-balance volume (OBV) indicator

The interpretation of this volume indicator does not depend on its absolute value.

In fact, OBV does not provide oversold or overbought levels typical of oscillators like Stochastic or RSI.

For that reason, traders study OBV line properties, looking for trends, trading ranges and zone of support and resistance:

On-balance-volume-indicator-in-US-stock-market-on-a-daily-chart-Google

Main goal is to spot footprints of big institutional investors, the so-called smart money. I’m talking about pension funds, mutual funds or even central banks who usually enter/exit from the market with huge amounts of positions.

Let’s now see how to calculate OBV trough its formula.

On-balance volume (OBV) formula – how to calculate this volume indicator

It’s super easy to calculate on-balance volume: it is a running total in which volume is added on up-days (today’s closing price > yesterday’s closing price) and subtracted on down-days (today’s closing price < yesterday’s close price).

Thus, OBV calculation is the following:

  • (+) If today’s close > yesterday’s close – volume is added;
  • (-) If today’s close < yesterday’s close – volume is subtracted;
  • (=) If today’s close = yesterday’s close – the variation is equal to zero;

Luckily for us, OBV indicator is market standard for almost every trading platform. Personally, I like tradingview.com a free and intuitive technical analysis platform:

How-to-use-tradingview.com-to-plot-OBV-on-price-chart

Main usages of on-balance volume (OBV) indicator

OBV applications are multiples.

We know that price should follow volume: this last represents buying and selling pressure in market. That’s why, through the divergence analysis (disagreement between price/volume), OBV can be used to spot early signs of potential reversal in price action.

But that’s not all. OBV works great also as trend confirmation or as a breakout confirmation filter.

 Let’s see each usage in detail.

1st use: OBV divergence – spot early sign of reversal in markets

In technical analysis, a divergence is a condition in which price action is not confirmed by a technical indicator. In the case of OBV, divergence spot a condition in which price action does not follow volume.

OBV divergences are footprints of big institutional players. Let’s consider the example below:

A-bearish-divergence-between-on-balance-volume-and-price-trend

During an uptrend phase, a divergence indication in OBV might spot on an early basis a potential future reversal in price action. Volume shows an increasing selling pressure, meaning that big institutional players (the true market movers) are starting to close their positions taking profit. Eventually, when counterparts are not able to balance the market, price reverse in the opposite direction.

Divergences can be spotted even during consolidation phases.

4 types of OBV divergences exist:

  • During a consolidation phase, if OBV is rising, it could be prelude to an upward breakout;
  • During a consolidation phase, if OBV is falling, it could be prelude to a downward breakout;
  • During an uptrend, if OBV is falling, it could be prelude to a change in price direction (negative divergence);
  • During a downtrend, if OBV is rising, it could be prelude to a change in price direction (positive divergence);

Here below an example of divergence during a consolidation phase:

A-bullish-divergence-between-OBV-and-price-on-US-stock-market-Morgan-stanley

Remember: OBV does not provide selling or buying signals, at least on an individual basis. It provides us with hints about the possible future behavior of price. It should be combined with price action considerations (like breakouts, presence of price barriers, candlestick patterns, etc.) or with other window technical indicators to enter in a trade.

2nd use: OBV for trend confirmation

Divergence analysis is not the only way to use on-balance volume.

Indeed, we can use OBV to confirm the strength of an existing trend:

OBV-and-price-convergence-in-EURUSD-market

Look at the picture above. When price follow a similar path to OBV, we can say that price is perfectly aligned with volume flows. Thus, there is a convergence between price and volume, a healthy signal for the continuation of market trend.

3rd use: OBV breakout from consolidation

Lastly, OBV can be used to confirm or anticipate breakouts from consolidation ranges. Look at the example below:

on-balance-volume-confirms-breakout-from-consolidation

We can observe how OBV broke above from consolidation before price. In this case, the on-balance volume was able to anticipate price action, providing a good market opportunity.

On-balance volume vs Accumulation Distribution Line – Which is better?

Both on-balance volume (OBV) and accumulation distribution line (A/D or ADL) are volume-based technical indicators. Difference relies on their construction methodology.

ADL construction is a bit more complicated than OBV, but this doesn’t mean that one indicator is better than the other.

What can really give you a hedge, is to combine them to confirm one another.

Interpretation is the same seen for OBV. The only difference is that by studying this indicator in comparison with Accumulation Distribution Line, we can improve the accuracy of the signals:

on-balance-volume-vs-accumulation-distribution-line-on-DAX-index

Conclusion – Key takeaways

Let’s make a brief recap of the main takeaways for OBV indicator:

  • OBV is a volume-based indicator used to identify buying and selling pressure in the market;
  • Its absolute value is not important: OBV is not an oscillator but is a cumulative total. Interpretation of this indicator relies only on slope analysis;
  • Price should follow volume flows: any OBV divergence is a signal of potential reversal in the market;
  • OBV can provide trend confirmation signals or spot early opportunities of breakouts from consolidation;
  • There is not a best indicator between OBV and A/D indicator. They can be combined together to improve the accuracy of market signals.

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