Dec 28, 2022 16:18
As a technical trader, you have a variety of trading indicators to select from. Despite their differences in terms of the formulas they use and the types of data they examine, they all have one thing in common: they make it easier to explain the movements of the markets. The On Balance Volume indicator, sometimes known as "OBV," is a trading indicator that employs two distinct data streams to assess the markets.
On-Balance Volume (or OBV) is a momentum indicator that predicts future trends based on market price and trading volume. Traders use it to gauge the audience's attitude and institutional investors' trading direction, which are highly powerful in determining bullish and bearish market conditions.
The on-balance volume (OBV) is a technical trading momentum indicator that predicts stock price fluctuations based on volume flow. In his 1963 publication Granville's New Key to Stock Market Profits, Joseph Granville introduced the OBV metric.
Granville believed that volume was the driving force behind markets, and thus he created OBV to predict when significant market movements would occur based on volume fluctuations. His book compared the OBV-generated predictions to a tightly wound spring. He felt that when volume increases significantly without a corresponding change in the stock's price, the stock's price will eventually leap up or down.
To help you comprehend the OBV indicator, let's examine its operation.
The OBV indicator is cumulative, so let's begin by stating that. This means that every time the price of the instrument changes, the cumulative OBV volume is changed.
If the price increases, for instance, the volume is added to the OBV. Moreover, if the price falls, the volume is deducted. A third scenario involves the price remaining unchanged, and in this instance, neither volume is added nor decreased.
Depending on the situation of the market, the OBV might have a positive or negative value. Positive values are recorded when today's price is higher than yesterday's closing price, and negative values are recorded when today's price is lower than yesterday's closing price. Additionally, the OBV indicator is visible, swinging about the zero line.
However, traders care less about the exact numeric value of the on-balance indicator due to the way it functions. Traders pay close attention to the indicator's direction and rate of change, as well as the line's slope. As an OBV indicator, this is how it looks on a graph:
At the bottom of the chart, a blue line represents the OBV. You can also view the indicator's numerical value, although it is not viewed as significant. Instead, it is prudent to concentrate on the slope and overall direction of the line because they provide a more accurate indication of purchasing and selling pressure.
The theory underlying OBV is based on the distinction between institutional investors and individual investors with less sophistication. As mutual funds and pension funds begin to acquire the security that ordinary investors are selling, the volume may rise while the price remains relatively stable. Eventually, volume causes a price increase, and at that point, larger investors begin selling while smaller investors begin purchasing.
The real individual quantitative value of OBV is irrelevant, despite being shown on a price chart and quantified mathematically. The indicator is cumulative, but a designated starting point determines the time interval. Hence the actual value of OBV depends arbitrarily on the beginning date. Instead, traders and analysts focus on the type of OBV fluctuations over time; the slope of the OBV line carries the entirety of the analytical weight.
Analysts utilize OBV volume figures to follow huge institutional investors. They interpret volume and price discrepancies as a proxy for the relationship between "smart money" and the dispersed masses in an effort to identify purchasing opportunities against erroneous prevalent trends. For instance, institutional capital may drive up the price of an asset, then sell once other investors follow suit.
As previously said, the absolute value of the OBV is irrelevant; thus, it is vital to focus on the general trend of the price and the indicator. The following can be determined by examining them:
There is a likelihood that an uptrend will continue when both the on-balance volume and closing price bars are setting higher highs.
When both the OBV and the price bars close with lower lows, there is a significant likelihood that the downtrend will persist.
If the asset price continues to make new highs while the OBV does not, it may signal a decline in bullish momentum.
If the asset price continues to make lower lows, but OBV does not follow suit, the bearish trend will likely stop.
If the price varies within the support and resistance levels but on-balance volume increases, this may signal an imminent upward price breakout.
If the price remains within the support and resistance lines, but the OBV indicator is falling, this could be an indication of an impending price decline.
On-balance volume is a cumulative indicator; when a price rises, it adds volume, and when it falls, it subtracts volume. Consequently, OBV is computed as follows:
When the price of today is greater than the price of yesterday
OBV = OBV (yesterday) + Volume today
When both prices (yesterday's closing price and today's closing price) are equivalent.
OBV = OBV (yesterday)
When today's closing price is lower than yesterday's closing price
OBV = OBV (yesterday) – Volume today
To address this question, we should focus on the current market volume and volatility. Since the OBV indicator was first developed in the 1960s, both have made significant advancements.
Currently, both trading volume and volatility are increasing. The markets have changed in such a way that we now trade at significantly more volatile prices than ever before.
Now, let's consider what this means in relation to the OBV indicator.
While the OBV indicator is effective in both low-volume and high-volume markets, it cannot be depended upon during periods of volatility. Short-term price spikes or drops, flash crashes, and the cancellation of trades — all of these modern market characteristics affect the trading volume and destabilize prices. This can cause the OBV to exceed its limits and increase the production of misleading signals.
As the Flash Crash demonstrates, even a retail trader can destabilize an entire asset class by generating false trading volume on his computer. Today's markets are technologically more advanced but more fragile.
Using the on-balance volume in conjunction with other indicators is worthwhile today. Thus, it can aid in the identification of trend reversals, confirmations, and divergences, thereby enhancing your trading strategy.
However, in the current market scenario, it is not worthwhile to use it alone. Using the OBV as the sole indicator of your trading strategy is a prescription for disaster.
A straightforward computation.
As a leading indicator, OBV can provide signals for a probable breakout or breakdown during sideways market movement.
As a cumulative indicator, OBV can be utilized to validate the direction of the trend.
It provides a mechanism for traders to discover divergences.
Market makers and high-speed traders frequently exaggerate volume figures by issuing fictitious orders and canceling them just before execution. A significant increase in trading volume can temporarily throw off the indicator. If you rely only on it, it may mislead you into making a trading decision too quickly due to a false trend.
The OBV is a leading indicator that generates signals without revealing anything about them. The trader cannot study the variables that led to a particular signal due to the lack of data. For example, the OBV adds or subtracts the same volume every time, regardless of the price. A few pennies or a few dollars is a trivial sum.
This renders the indicator inconclusive in terms of price analysis information. Therefore, each created signal requires a leap of faith on the part of the trader.
Although this is true for virtually all indicators, it is especially true for the OBV. Due to the lack of conclusiveness of volume analysis, traders must frequently supplement the indicator with others, such as adding an MA line to the OBV to search for breakouts.
Traders employ the indicator as part of an on-balance volume trading strategy to forecast price moves or to confirm price trends. The computation is based on pricing and volume discrepancies.
Bullish divergence — When the price action reduces and the OBV rises simultaneously; you should expect upward price movement. The price will exhibit lower lows for a bullish divergence, while the indicator will exhibit higher lows.
Bearish divergence – A bearish divergence is discovered when the price continues to rise while the OBV indicator declines. A bearish divergence exists when the price exhibits higher highs, and the average volume exhibits lower highs.
Confirming the trend — To confirm the direction of the trend, observe whether the OBV line follows the price in the same way. If the average volume rises as the price rises, this confirms an increasing trend, and the volume rises to support the price increase.
Possible breakout or breakdown from the ranging market - During ranging market conditions, a rising or falling on-balance volume indicator value can signify a potential price breakout or breakdown. A rising OBV line can signal a possible upward breakout since accumulation is occurring.
Due to the distribution, a declining on-balance volume line may indicate probable price breakdowns. The figures below illustrate how OBV confirmation operates and how a divergence would appear.
The fact that the price is rising and making higher highs is observable evidence of an upward trend. Traders confirm the trend direction by examining the direction of the OBV indicator. It is evident that the indicator line is rising and moving in tandem with the price motion.
Divergence alerts can be generated when the price action and the indicator move in opposite directions. As a result, a bullish divergence signal may be observed on the graph, as the price has lower lows than the OBV indicator.
To combine the OBV indicator with other tactics, technical analysis is required. Technical analysis is a method for predicting the future price of security using historical price information. Moving averages, support and resistance levels, and Fibonacci levels are among the most commonly utilized technical indicators.
When performing technical analysis, it is essential to understand that no single indicator is flawless, and this is why it is essential to corroborate signals with numerous indicators. If you observe a positive divergence on the OBV indicator, you may check for confirmation using a moving average or a support and resistance level.
The OBV can be coupled with other trading strategies to assist traders in making more informed selections. It is essential to note, however, that no indicator is flawless. Use the OBV in conjunction with other indicators and price action to confirm signals.
Both on-balance volume and the accumulation/distribution line are momentum indicators that utilize volume to forecast the movement of "smart money." Nonetheless, the parallels cease here. Calculating on-balance volume involves adding the volume on an up-day and subtracting the volume on a down day.
The formula used to construct the accumulation/distribution (Acc/Dist) line differs significantly from that used to calculate the OBV displayed above. Without getting too technical, the Acc/Dist is calculated by multiplying the current price's position relative to its recent trading range by the period's volume.
The cumulative delta volume indicator is one of the indicators traders frequently use to compare OBV. In addition to being volume indicators, they share a few other commonalities.
However, while the cumulative delta volume indicator only displays volume on the bid and ask sides, the OBV considers the total volume in play. It accomplishes this by combining the delta values of all bars to generate a graph. When a trader attempts to determine the buying and selling pressure at various price levels, the indicator is helpful (i.e., swing highs and lows).
Consider OBV to be the more comprehensive indicator and cumulative delta volume to be the niche indicator. While the OBV provides a more comprehensive view, the cumulative delta indicator reveals just extremes.
Both indicators are useful to order flow traders, who may employ either one depending on the circumstances.
OBV capitalizes on this concept by maintaining a running tally of volume as price changes direction. On up days, volume (such as the number of shares) is added to the indicator. On down days, the indicator's volume is removed.
When in balance, Volume and price always move in the same direction; thus, we can draw a trend line on both price and volume to observe pattern similarities.
In addition, OBV should always be utilized in conjunction with the daily closing chart. OBV can be utilized in any type of system, including trend/momentum tracking and price reversal. Traders that follow trends may use the OBV's signals in conjunction with trend-identifying indicators. Combining it with other confirmation indicators, such as Stochastic, can help you make more profitable bets.
When the market is stable, the on-balance volume is the most reliable. Such as when volatility is low and especially when applied to longer time frames. The indicator is useful for detecting potential trend reversals and trend confirmations. Nonetheless, you shouldn't use its indications as your only justification for entering a trade. Using the OBV in conjunction with other indicators is best to get the most accurate results.
A strong OBV suggests positive volume pressure in anticipation of price increases. Similarly, lowering OBV indicates negative volume pressure in anticipation of declining pricing.
A negative on-balance volume signifies two things: 1) today's price is lower than yesterday's closing price, and 2) today's trading volume is larger than yesterday's trading volume. A negative volume on balance typically indicates increased selling pressure and a possible bearish trend.