What should you look for in a good trade? Volume! Well, volume amongst other factors. But in any case, volume is a crucial component of a successful trading strategy. Volume plays an important role in technical analysis with the most popular volume analysis tool being the On Balance Volume Indicator. Traders will look at OBV when deciding whether a trade is worth entering.
In this article, we will take you through what is the OBV Indicator and how to best utilize it in your trading strategy. However, before we even touch on the OBV trading indicator, let’s first understand why volume is such a critical component of a good trade.
Why is Volume Important in Trading?
Volume is a strong force behind the markets. Technically speaking, it is the measure of how much a financial instrument has been traded in a period of time. For Stocks, this means the number of shares that have been traded. For Options and Futures, volume measures the number of contracts that have changed hands.
But there is far more to ‘volume’ than this simple definition.
Traders will often look to volume as a strong indication of overall market strength and the strength of a specific financial asset.
The key is liquidity. When there is high trade volume, this is a good indication of high liquidity in the asset. This means better order execution, minimal slippage, and more risk control as traders are in a far superior position to close trades and walk away with realized profits.
If we stop and think about it, every transaction needs a buyer and a seller. When there are large numbers of buyers and sellers participating in the market, this means that trading volume is high. It is generally easier to buy and sell stock in a high volume environment as there are many other traders waiting on the sidelines to buy from and sell to.
There are two key concepts behind volume analysis: buying volume and selling volume which make up the total volume.
Buying Volume occurs at the ‘ask price’. The ‘ask price’ is the lowest price a trader will sell a financial instrument. When the volume of traders purchasing at the ‘ask price’ increases, this will generally push up the price of the asset. However, buyers will need increasing numbers of other buyers and increasing enthusiasm in the market to keep pushing prices even higher.
Selling Volume occurs at the ‘bid price’. The ‘bid price’ is the highest price a trader will pay for an asset. When more transactions occur at the ‘bid price’ this will generally push the price down.
When selling volume outweighs buying volume, the stock price will start to move in a downward trend. It will generally take a large influx of buyers in the market to reverse the price back up. Traders will often see the market consolidate for a period of time as buy and sell orders cancel each other out. As volume builds in one direction, only then will price move in the corresponding direction.
Trading Volume is often shown in vertical bars or histograms plotted on a stock chart. Each bar shows how many shares or contracts have changed hands over a certain period of time. The taller the bar, the higher the volume. While a shorter bar shows lower volume. The bars are also typically color coded red or green, where:
- Red is Selling Volume. The price has declined during the time period.
- Green is Buying Volume. The price has increased during the time period.
What Is The Best Volume Indicator?
While traders can certainly look at the volume histograms alone, there are also a number of popular indicators available that use volume data. These indicators can help traders see and interpret volume to better understand what is happening in the market. We briefly summarise a few of the most popular below.
Chaikin Money Flow Indicator
The Chaikin Money Flow Indicator is an oscillator that moves between -1 and +1. It uses money flow volume usually over a 21 day period.
When the indicator is in positive territory there is an increase in buying pressure. Conversely, when the indicator moves below zero and into negative territory there is an increase in selling pressure. It is common for traders to use the Chaikin Money Flow Indicator to spot Bullish and Bearish Divergences.
The Klinger Oscillator compares the volume flow with the price movement of an asset. It is used by traders to identify long-term and short-term trends in money flow. The Klinger Oscillator uses a fairly complex calculation that involves using price and volume to create two exponential moving averages. The indicator then takes the difference between those two moving averages and represents the data as an oscillator. A signal line is then added to provide even more buy and sell trade signals.
On Balance Volume (OBV) Indicator
This brings us to the On Balance Volume Trading Indicator. Hugely popular among traders, a personal favorite of ours and the focus of the latter part of this article!
The On Balance Volume Indicator
The On Balance Volume Indicator is a simple but effective tool to help interpret volume action in many financial markets. It is a leading indicator that is widely popular among traders as it produces clear signals that are easy to interpret.
What does On Balance Volume (OBV) Mean?
The On Balance Volume Indicator was developed by Joseph Granville and published in his book ‘Granville’s New Key to Stock Market Profits’ in 1963. Granville believed that volume preceded price action and was the key force behind markets. In his book, Granville likened OBV signals to a “spring being wound tightly” – where a sharp increase in volume without an accompanying change in price would result in an eventual launch of price either upward or downward.
The On Balance Volume Indicator is often used in technical analysis as it reveals the intent of market traders even before price action shows signs of upward and downward trends. It does this by using a simple accumulation distribution method that provides a running total of positive and negative volume. This is displayed as a smooth line plotted underneath a stock chart and produces more actionable signals than the default volume histogram.
How is the On Balance Volume (OBV) Indicator Calculated?
OBV is a cumulative indicator. It involves a simple calculation that essentially keeps a running tally on positive and negative volume. When an asset price increases, the volume is added to the current OBV. When an asset price decreases, the volume is subtracted from the running total.
The calculation for the OBV Indicator can be summarised in three simple rules.
Rule One – Closing price is greater than the prior closing price
Current OBV = Previous OBV + Current Volume
Rule Two – Closing price is less than the prior closing price
Current OBV = Previous OBV – Current Volume
Rule Three – Closing prices is the same as the prior closing price
Current OBV = Previous OBV
How Do I Use the On Balance Volume (OBV) Indicator?
The actual quantitative OBV value is not important. What is important is the slope of the OBV line. A rising OBV line means that there is positive buying volume which is indicative of an increase in stock price. Conversely, a falling OBV line represents positive selling pressure which signals a fall in stock price.
However, to understand the full extent of the OBV Indicator’s usefulness, traders will need to do a simple process of comparing the OBV line with price changes. It is this relationship between the movement of the OBV line and price that generates the buy and sell signals traders want to see.
Steps to Analyzing On Balance Volume (OBV)
To analyze On Balance Volume (OBV) and see a more holistic picture of how volume is affecting the financial security, it may be helpful to complete the following steps:
Step One – Define the OBV trend – Is the OBV line rising, signaling positive buying pressure or falling indicating more selling pressure?
Step Two – Does the OBV trend match the underlying asset? Is there convergence or divergence?
Step Three – Where are the support and resistance levels? Where price breaks through these levels of support and resistance, how does the OBV line respond? Does the OBV line generate any strong buy or sell signals?
OBV and Trend Confirmation
On Balance Volume (OBV) can be used to confirm price trends. Where volume supports price action this creates convergence. This can be seen in Step Two where the trend in the OBV line corresponds with the trend in the underlying asset’s price.
Where both the price and OBV line are rising, this is a signal that the price will continue to climb. Vice versa, where the price and OBV line are both falling, traders can continue to expect the downward trend in price to continue.
The degree of slope in the OBV line is critical to confirm the strength of the signal. Price movements on a slightly sloped OBV line is not a strong indicator. Price changes of a steep-sloped OBV line is a strong indicator.
OBV and Divergences
On Balance Volume (OBV) can be used as signals for trend reversals. Where volume does not support price action, this creates divergence.
Bullish Divergence occurs where the OBV line moves higher while the underlying asset’s price continues to fall. As volume precedes price, a bullish divergence creates a buy signal as the price is expected to reverse and launch upwards.
Bearish Divergence occurs where the OBV line moves lower while the underlying price rises. Just like a tightly wound spring, bearish divergences create a sell signal and traders can expect the price to reverse and launch back down.
OBV, Breakouts and Breakdowns
On Balance Volume (OBV) generates the most reliable signals around tests of major high and major lows. This makes the indicator ideal for scouting potential breakouts and breakdowns.
When the stock price is moving in a trading range and OBV is rising, this is a sign that accumulation is taking place and can be an early warning of an upward breakout. Conversely, where OBV is falling while the price is range bound, this is indicative of distribution taking place and can be an early warning of a downward breakdown.
Limitations of On Balance Volume (OBV) Indicator
No indicator is perfect and On Balance Volume does have its limitations. But like all indicators, the best way to combat these weaknesses is to know about them, expect them, and prepare for them.
Large Spikes in Volume
Company announcements, news releases, and a multitude of other reasons can cause traders to either become excited or concerned about a stock’s price potential. This can lead to a mass of buying or dumping of stock. This sudden increase in volume can throw off an OBV Indicator for a period of time. This is because volume is added or subtracted to the running OBV total. One large spike in volume will require a settling period. During this settling period, the OBV indicator will not be reliable in providing trend confirmation or price reversal signals.
Not a Standalone Indicator
On Balance Volume is not a standalone indicator. A criticism of OBV is that it doesn’t account for the degree in price movement. Regardless of whether the stock price moves by a few cents or hundreds of dollars, if the closing price is greater than the prior closing price, volume will be added to the OBV running total. This doesn’t provide a holistic view of price action which in turn can create misleading or confusing trade signals.
One way to combat this is to pair OBV (a leading indicator) with a lagging indicator such as a moving average. A long-term moving average can be plotted on top of the OBV line (not the price chart) and can provide additional confirmation of trend direction. Where OBV is moving above the moving average, this confirms an upward trend. Conversely, an OBV below the moving average confirms a downward trend.
Now that we’ve come to the end of the article, we thought we’d do a short recap and some handy tips on volume and the OBV Indicator:
- Don’t ignore Volume. If a stock has low liquidity, this is a red flag. If a leap in price isn’t accompanied by a surge in volume, this is also a red flag.
- OBV is a simple indicator that uses volume to confirm price trends, look for bullish divergence, bearish divergence, and spot potential breakout and breakdowns.
- You can use OBV in conjunction with basic chart analysis or other technical indicators to confirm market signals and improve your overall trading success.
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