On-balance volume (OBV) assesses the intensity of buying and selling in the market by accumulating volume during bullish days and subtracting volume on bearish days. Let's see how it works in detail.
What is equilibrium volume?
On Balance Volume is a powerful technical analysis tool created by Joseph Granville. It helps traders understand the relationship between price movement and daily trading volume.
OBV is a cumulative indicator that adds daily volume to a running total when the closing price is higher and subtracts it when the closing price is lower. To calculate OBV, add or subtract the daily volume from the previous OBV depending on whether the price increased or decreased.
Granville highlighted that the OBV is a key driver of stock market gains as it reflects buying and selling pressure and helps confirm the prevailing trend. Understanding this indicator can be crucial to predicting price movement and making informed decisions in the stock market.
Example of volume chart at equilibrium
What does the OBV indicator tell you?
On Balance Volume is an indicator that accumulates the volumes of a security according to the direction of the price variation. It allows to evaluate the buying or selling pressure through the volumes.
In this way, this indicator allows to measure the strength or weakness of a trend and to identify the risks of a reversal of the trend. The On Balance Volume is based on the principle that prices represent the bullish or bearish consensus on the value and the volumes represent the commitment of the participants.
A rising OBV shows that buyers are very strong and vice versa if the indicator falls. As noted by Dr. Alexander Elder, a renowned trader and author: “When the OBV is not heading in the same direction as prices, collective emotions are not in tune with the collective consensus.”
“The crowd will more readily follow its heart than its reason. This is why changes in volume direction often precede changes in price.”
Calculation of volume in equilibrium
How to calculate the balance volume? This indicator calculates a relationship between the change in volumes and prices. We can calculate it by adding the volumes on the day when the price rises and subtracting the volumes on the day when the price falls.
The OBV accumulates volumes as follows:
- When the value closes higher, all volume for the day is considered as up volume. The volume for the day is added to the previous cumulative total.
- When the value closes lower, all volume for the day is considered as down volume. The volume for the day is subtracted from the previous cumulative total.
Formula for volume in equilibrium
The calculation formula is as follows:
Close higher:
OBV = OBV(n-1) + Volume
Close lower:
OBV = OBV(n-1) – Volume
If prices have not changed:
OBV = OBV(n-1)
This is a cumulative indicator since we calculate it by adding the volumes of the day when prices rise and subtracting the volumes of the day when prices fall from the value of the indicator in n-1.
How to use the On Balance Volume Indicator in day trading?
Let's take an example:
- If the daily volume is 1000 shares and the closing price is higher than the previous day, 1000 is added to the OBV.
- If the daily volume is 800 units and the closing price is lower than the previous day, 800 is subtracted from the On-Balance Volume.
- If the daily volume is 500 units and the closing price is the same as the previous day, then the OBV remains unchanged.
Volume in balance in technical analysis
A rising OBV shows where the astute investors in the market are. When the crowd follows the price movement, the OBV and the value will rise together. On the other hand, if prices move ahead of the OBV, we have a non-confirmation. Non-confirmations occur when the market is at its extremes.
If, in an uptrend, the OBV turns bearish, this means that there were much higher volumes during downtrend sessions than during uptrend sessions, even if there were more uptrend sessions. Therefore, there is a high probability of a reversal to the downside.
On the contrary, if the Volume in equilibrium If the trend turns bullish in a downtrend, there were much higher volumes during the uptrend sessions than during the downtrend sessions, even if there were more downtrend sessions. The probability of a bullish reversal then becomes very high.
The graphical reading of the On Balance Volume can be associated with the detection of divergence between the evolution of the price and that of the indicator.
It is quite possible to calculate a moving average of the OBV using the crossovers of the two curves. When the moving average crosses the OBV downwards, it represents a sell signal; otherwise, it is a buy signal.
The logic behind this system is as follows: volumes precede the trend. When prices are stable or correcting the trend, an increase in volume allows us to anticipate the beginning of the resumption of the trend. Similarly, at the end of a trend, we theoretically see a decrease in volume before prices fall.
OBV vs Accumulation/Distribution
Both the breakeven volume and the accumulation/distribution line serve as momentum indicators that leverage volume to forecast the actions of the “smart money.” However, their methods differ significantly. To calculate breakeven volume, you add the volume on days when prices are rising and subtract the volume on days when prices are falling.
The Accumulation/Distribution (Acc/Dist) line, on the other hand, employs a different approach. Its formula considers the current price position within its recent trading range and multiplies it by the volume for that specific period, allowing it to provide insight without becoming overly complex. So, while both indicators focus on volume, their calculations and implications differ substantially.
Limitations of OBV
One drawback of the on-balance volume (OBV) indicator is that it acts as a leading indicator. It can generate forecasts, but it offers limited insight into past market actions based on its signals.
This feature makes it susceptible to false signals. To mitigate this, we can add lagging indicators. Incorporating a moving average line with the OBV can help identify breakouts. If the OBV experiences a breakout simultaneously with price movements, it can validate the breakout.
Also, it is important to be careful with the OBV, as a significant increase in volume in a single day can distort the indicator for an extended period.
For example, unexpected earnings reports, changes in index composition, or large institutional transactions can cause significant fluctuations in the indicator. However, these sudden changes in volume may not necessarily reflect an ongoing trend.
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