How to Use On-balance Volume in Day Trading - dummies

How to Use On-balance Volume in Day Trading

On-balance volume is a running total of the amount of market trading in a stock or commodity. To calculate the on-balance volume as a day trader, first look at today’s closing price relative to yesterday’s and then do one of the following:

  • If today’s close is higher than yesterday’s: Add today’s volume to yesterday’s on-balance volume.

  • If today’s closing price is less than yesterday’s: Subtract today’s volume from yesterday’s total.

  • If today’s close is the same as yesterday’s: Don’t do anything! Today’s balance is the same as yesterday’s.

Many traders track on-balance volume over time, and here’s why: A change in volume signals a change in demand. The change in demand may not show up in price right away if enough buyers exist to absorb volume from sellers.

But if still more buyers are out there, then the price is going to go up. Hence, the volume from even small day-to-day increases in price need to be added up over time. If the volume keeps going up, then at some point, prices are going to have to go up to meet the demand.

On the downside, the volume from small price declines add up over time, too. Over time, this volume may show that very little pent-up interest exists, indicating that prices could languish for some time.

Many traders look to on-balance volume to gauge the behavior of so-called smart money, such as pension funds, hedge funds, and mutual fund companies. These big institutional accounts tend to trade on fundamentals rather than emotion.

They generally start buying a security at the point where the dumb money is tired of owning it, so their early buying may show big volume with little price change. But as the institutions keep buying, the price has to go up to get the smarter individuals and the early institutions to part with their shares.