Using Technical Analysis to Track On-Balance Trading Volume - dummies

Using Technical Analysis to Track On-Balance Trading Volume

On-balance volume (OBV) is a running (cumulative) total of investment trading volume, calculated by adding the volume on days the price is higher than the day before and subtracting the volume on days the price is lower than the day before.

The logic goes like this: At the simplest level, when the price closes higher than the day before, demand was greater than supply at each price level. Buyers had to offer higher prices to get holders to part with their shares. You can attribute all the volume on a higher-close day to net buying and all the volume on a lower-close day to net selling.

The following figure, which shows IBM stock, indicates daily prices in the top part, volume (in hundreds of thousands of shares) in the center, and the OBV indicator in the bottom window.

On-balance volume.
On-balance volume.

OBV doesn’t work all the time, but a change in the indicator often precedes a change in the price. Using the above figure, you can see how to use the OBV indicator in two instances:

  • The downmove: The price downmove, already in progress, is suddenly accompanied by a big rise in volume. The increase in volume starts the day before the downward gap. A falling price punctuated by a downward gap is a message to the market that the price is going to fall some more.

    In this case, the OBV indicator forecasts the impending bottom. It starts to fall ahead of the volume spike and ahead of the gap. If you own the stock and see the OBV indicator start to decline and then you see spiky volume (like the area in the ellipse), you should sell. Holding on after the downward gap is courting a fat loss.

  • The upmove: OBV reaches its lowest levels about two weeks before Pivot Day 1, which features the lowest low in the series of lower lows, but a higher closing price and a gap upward the following day. Notice that OBV is already rising while the price is still falling, a divergence that is a critical clue to an impending change in the direction of the price.