We can trace the On-Balance-Volume (OBV) back to Joseph Granville in 1963. He believed that the On Balance Volume indicator is an effective way of measuring the strength and weaknesses of a security price movement. Since then, OBV has become one of the most widely used technical indicators by traders and investors alike.
Background
On-Balance-Volume (OBV) is a technical indicator that tracks the total amount of buying and selling pressure in security. We calculate it by adding all volume on up days, subtracting all volume on down days, and then cumulatively summing the results. The idea behind OBV is that if most traders are buying, the total amount of volume should increase. If they are selling, then the total amount of volume should decrease. By tracking this net balance over time, investors can get an idea of whether there is a trend in the security price movement.
When interpreting OBV, the primary focus should be on the trend. A rising trend in OBV shows buyers are increasingly active, which may lead to a price increase. Conversely, a falling trend in OBV suggests sellers are becoming more dominant, which could mean a drop in price is imminent.
When looking at the absolute value of OBV instead of its trend, high OBV values suggest strong buying pressure, and low values can point to heavy selling pressure. However, these absolute levels can vary drastically depending on the security being analyzed, so it’s important to consider all other factors before deciding.
How to calculate OBV
Knowing how to calculate OBV is essential if you want to make informed decisions for investments.
The On Balance Volume (OBV) calculation method states that:
- if the security’s closing price is higher than the previous day’s close, then one should add the volume while
- if the closing price is lower than the previous day’s, then one should subtract the volume.
- If the closing prices of both days are equal, then nothing needs to be done, and the OBV remains unchanged at its prior level.
Following this easy formula might make all the difference in getting maximum returns on your investments.
How to use the OBV indicator
Traders can use OBV to determine potential entry and exit points, or as a confirmation tool for other trading strategies. By looking at the trend in OBV relative to price movements, traders can spot divergences that could signal an upcoming reversal. Here are three popular ways to use the indicator:
Follow and confirm trends
When there is a strong trend in OBV, it’s best to follow the trend. If OBV is rising, then the price is likely to go up and vice versa. Identify divergences: When the price of a security moves in one direction while OBV moves in another, this could be an indicator that the trend is about to end. This can be a good time to take profits or look for an exit point.
Combine with other indicators
You should not use OBV in isolation. It’s always a good idea to combine it with other technical indicators, such as moving averages or momentum indicators, to get a better sense of the current market sentiment.
Find divergences
When the price of a security moves in one direction while OBV moves in another, this could be an indicator that the trend is about to end. This can be a good time to take profits or look for an exit point. A bullish divergence occurs when the price of a security is making lower lows while OBV is making higher lows. A bearish divergence occurs when the price is making higher highs, while OBV makes lower highs.
OBV versus Accumulation/ Distribution indicator
The on-balance volume (OBV) and the accumulation/distribution line are both used to study momentum and predict the movement of “smart money” through the use of volume. But in the calculation, they are two very separate indicators.
OBV is determined by simply adding up the volume on an up-day while subtracting that of a down-day. The formula for the Acc/Dist line is more complex, as it is determined by considering the current price in relation to its recent trading range, which is then multiplied by that period’s volume.
These two indicators allow traders to move beyond simply considering price movements and gain insights into underlying market sentiment using data from past volumes of trades.
Advantages of using OBV indicator
1. OBV helps you identify potential reversals: by looking for divergences between the price and OBV, traders can spot potential reversals in trends.
2. OBV is simple to use: OBV considers only two factors — volume and price — which makes it easy to understand and interpret.
3. OBV does not lag price: we calculate OBV in real-time, which makes it a useful tool for tracking the current sentiment of the market.
4. You can use OBV across different timeframes: The indicator works on both short- and long-term timescales, so traders can use it to form both medium-term and long-term trading strategies.
5. OBV helps identify the strength of trends: By comparing OBV readings against each other, traders can judge whether a trend is gaining or losing momentum.
6. OBV accounts for volume: Many technical indicators ignore volume, but OBV considers both volume and price when calculating its values. This makes it a valuable resource when looking for potential entry and exit points in the market.
7. OBV helps identify overbought and oversold conditions: By looking at OBV readings, traders can spot when security is over-extended and may be due for a correction. This can help them make informed decisions about when to enter or exit a position.
Limitations of OBV indicator
1. OBV is a lagging indicator: While it can provide useful insights into the current market sentiment, it’s important to remember that OBV is a lagging indicator and may not predict future price movements.
2. Not suitable for all markets: OBV works best in markets with high liquidity and consistent activity. It may not be suitable for smaller, more illiquid markets.
3. No support-resistance levels: The indicator does not give any indication of potential support or resistance levels, making it difficult to identify entry and exit points with precision.
4. If the volume data used to calculate OBV is incorrect or incomplete, it can affect the accuracy of the indicator.
5. Few interpretations: OBV doesn’t provide much in terms of interpretation and it’s up to the trader to determine how they want to use it.
6. Subjective: The interpretation of a security’s volume activity is subjective, so traders should know different analysts may come to different conclusions.
7. OBV only serves as a tool for confirmation and cannot provide any definitive buy or sell signals. Therefore, one should always combine it with other technical indicators for a more complete analysis.
Conclusion
The On-Balance Volume (OBV) indicator is a powerful tool that can help traders identify potential reversals in trends, gauge the strength of trends, and spot overbought and oversold conditions. However, it’s important to remember that OBV is a lagging indicator and may not be suitable for all markets. Interpreting volume activity is subjective and traders should always combine OBV with other technical indicators for a more complete analysis. Despite these limitations, the OBV indicator can be an invaluable tool for any trader looking to gain insights into underlying market sentiment.
