What is On Balance Volume (OBV)

The On-balance Volume (OBV) is an important indicator in market analysis that helps understand price trends through price movements and trading volumes. It calculates buying and selling momentum by adding the trading volume on the days when the market closes higher and subtracting it on days when the market closes lower. OBV offers a peek into the volume-driven price movements, reflecting net volume shifts during price fluctuations. An upward-trending OBV indicates accumulation, reflecting increased buying pressure with higher volumes on rising days. Conversely, a downward-trending OBV denotes distribution, showing increased selling pressure with higher volumes on declining days.

Traders use OBV to assess trend strength, potential reversals, and entry points. Remember that it complements other technical indicators and should be used alongside other analysis methods for informed decision-making.

How is OBV calculated?

The calculation of on-balance volume (OBV) involves a straightforward yet insightful methodology. Here is the step-by-step process:

1. Initial value: Start by assigning an initial value to OBV, typically 0. This value represents the OBV at the beginning of the data series.
2. Volume calculation: For each trading period, calculate the volume. Volume is the total number of shares or contracts traded during that period.
3. Price change determination: Determine the price change from the current period to the next period. This change is usually calculated as the difference between the closing price of the current period and the closing price of the previous period.
4. Volume adjustment: Adjust the volume based on whether the price increased or decreased from the previous period. If the closing price increased from the previous period, add the volume to the OBV. If the closing price decreased, subtract the volume from the OBV.
5. Cumulative calculation: Cumulate the adjusted volume for each period to derive the OBV value for that period. This cumulative total is the OBV value for the current period.

Mathematically, the OBV calculation can be represented as follows:

• If the closing price of the current period is higher than the previous period:
  OBV (current) = OBV (previous) + volume (current)
• If the closing price of the current period is lower than the previous period:
  OBV (current) = OBV (previous) – volume (current)
• If the closing price of the current period is equal to the previous period:
  OBV (current) = OBV (previous)

By following this calculation method, the OBV line is constructed, providing a visual representation of the cumulative volume flow and aiding in the analysis of market sentiment and potential price trends. Traders often use OBV with other technical indicators to make informed trading decisions.

How do you interpret OBV?

Here are some key points to consider when interpreting OBV:

1. Trend confirmation: OBV is often used to confirm price trends. When the OBV line is trending upwards alongside rising prices, it suggests strong buying pressure, confirming the uptrend. Conversely, if the OBV line is trending downwards while prices are declining, it indicates increasing selling pressure, confirming the downtrend.
2. Divergence signals: Divergence between OBV and price movements can provide early signals of potential trend reversals. For example, if prices are making new highs, but OBV fails to confirm these highs by not making new highs as well, it could signal weakening buying pressure and foreshadow a possible reversal.
3. Volume confirmation: OBV can also be used to confirm the strength of price movements. A sharp increase in OBV accompanying a significant price move suggests strong conviction behind the price action. Conversely, if OBV fails to confirm a price move, it may indicate that the move lacks strong volume support and is more likely to be short-lived.
4. Breakout and support/resistance confirmation: OBV can help confirm breakout and support/resistance levels. When prices break out above resistance with a corresponding increase in OBV, it indicates strong buying interest supporting the breakout. Similarly, if prices test a support level and OBV shows accumulation, it suggests that buyers are stepping in to support prices at that level.
5. Volume analysis: OBV provides insights into volume trends, allowing traders to gauge the intensity of buying and selling pressure. Rising OBV suggests accumulation and increasing buying interest, while falling OBV indicates distribution and increasing selling pressure.
6. Confirmation with other indicators: While OBV can be a valuable tool on its own, it is often used with other technical indicators to validate signals and strengthen analysis. Combining OBV with indicators such as moving averages, momentum oscillators, or trend lines can provide more robust trading signals.

Example

Let us take a look at an example of using OBV in a real-world scenario. Imagine that the OBV values on several days of trading are 120, 170, 150, 210, 190, and 230. As the stock prices increase, the OBV will also climb, suggesting the possibility of a bullish trend. From this, traders might get the indication of entering the market or holding onto a long-term position.

How do you read OBV divergences?

Reading OBV divergences is an essential aspect of technical analysis, as it can provide early signals of potential changes in price direction. There are two primary types of divergences to look for:

1. Bullish divergence: Bullish divergence occurs when prices are making new lows, but OBV fails to confirm these lows and instead forms higher lows. This suggests that despite downward price movement, buying pressure is increasing, potentially signalling a reversal to the upside.
2. Bearish divergence: Bearish divergence occurs when prices are making new highs, but OBV fails to confirm these highs and instead forms lower highs. This indicates that despite upward price movement, selling pressure is increasing, potentially signalling a reversal to the downside.

When identifying divergences, it is crucial to consider the significance of the divergence in relation to other factors such as volume levels, price patterns, and the strength of the trend. Divergences are most effective when they occur with other confirming signals.

How do you use OBV for trend confirmation?

OBV can be a powerful tool for confirming price trends and assessing the strength of those trends. Here is how you can use OBV for trend confirmation:

1. Uptrend confirmation: In an uptrend, OBV should generally be trending upwards as well. Rising OBV alongside rising prices confirms the strength of the uptrend, indicating increasing buying pressure. If OBV fails to confirm new highs in prices, it may signal weakness in the uptrend.
2. Downtrend confirmation: In a downtrend, OBV should generally be trending downwards as well. Falling OBV alongside falling prices confirms the strength of the downtrend, indicating increasing selling pressure. If OBV fails to confirm new lows in prices, it may signal weakness in the downtrend.
3. Volume spike confirmation: Significant volume spikes accompanied by corresponding movements in OBV can confirm the strength of a trend. A surge in OBV alongside a price breakout or breakdown suggests strong conviction behind the move, increasing the likelihood of trend continuation.
4. Divergence confirmation: As mentioned earlier, divergences between OBV and prices can provide early signals of potential trend reversals. Confirming these divergences with other technical indicators or price patterns can strengthen the validity of the reversal signal.

By using OBV for trend confirmation, traders can gain more confidence in their analysis and make better-informed trading decisions.

Difference between OBV and Accumulation/Distribution

While both these indicators utilise volume data, their distinction lies in their approach. OBV exclusively considers the relationship between the closing prices of the current and previous days. In contrast, A/D takes into account the entire trading range of a day. What this essentially means is that A/D offers a more detailed picture of buying and selling pressures in the market in a set period.

Difference between On-Balance-Volume and Volume-Price Trend

Like OBV, the Volume-Price Trend (VPT) indicator integrates price momentum and volume.  However, unlike OBV, VPT also takes into account the percentage of change in prices, making it a more comprehensive and complex metric compared to OBV. Even though both indicators help enhance the understanding of market trends, you can select one of the two depending on your preferences and strategy.

Drawbacks of OBV

After learning about the calculation and interpretation of OBV, it is crucial to recognise that OBV also has limitations. One major drawback is that volume changes can be deceptive in low liquidity markets, reducing OBV's effectiveness and accuracy. Moreover, sudden price gaps can also potentially distort OBV readings. Thus, as a trader, you should combine OBV with other technical analysis indicators to gain a more accurate assessment of the market conditions.

Conclusion

On-Balance volume (OBV) is a valuable technical indicator that provides insights into market sentiment and helps traders assess the strength of price trends. When interpreting OBV, traders look for trends, divergences, volume spikes, and confirmation signals to make informed trading decisions. While OBV can be a powerful tool on its own, it is most effective when used with other technical indicators and analysis methods.

By incorporating OBV into their trading strategies, traders can improve their ability to identify profitable trading opportunities and navigate the dynamic nature of financial markets with greater confidence.