OBV Explained

1. OBV Explained

On Balance Volume (OBV) is a momentum indicator used in Technical Analysis to relate price change to volume. Developed by Joe Granville, OBV attempts to show whether volume is flowing into or out of a security. It’s a cumulative volume indicator, meaning it adds volume on up days and subtracts volume on down days. This article provides a comprehensive explanation of OBV, covering its calculation, interpretation, strengths, weaknesses, and how to use it effectively in your trading strategy.

Understanding the Core Concept

The fundamental idea behind OBV is that volume precedes price. Granville believed that volume is a leading indicator, and that changes in volume can foreshadow changes in price. If volume is increasing on up days and decreasing on down days, it suggests buying pressure is building, potentially leading to a price increase. Conversely, if volume is increasing on down days and decreasing on up days, it suggests selling pressure is building, potentially leading to a price decrease.

Think of it like this: a rising tide (buying pressure) lifts all boats (prices). If more and more people are buying (high volume on up days), the price is more likely to rise. A receding tide (selling pressure) lowers all boats. If more and more people are selling (high volume on down days), the price is more likely to fall. OBV aims to quantify this "tide" of buying and selling pressure.

How OBV is Calculated

The OBV calculation is relatively straightforward. Here's a step-by-step breakdown:

1. **Start with a Base Value:** The OBV starts with an initial value, typically zero. Some platforms may use the first day’s volume as the starting point.

2. **Up Day:** If the closing price is higher than the previous day's closing price, the day's volume is added to the previous OBV value.

3. **Down Day:** If the closing price is lower than the previous day's closing price, the day's volume is subtracted from the previous OBV value.

4. **Neutral Day:** If the closing price is the same as the previous day's closing price, the OBV remains unchanged.

Formula:

OBV = Previous OBV + (Current Volume if Price Up) - (Current Volume if Price Down)

Let's illustrate with a simple example:

| Day | Closing Price | Volume | Calculation | OBV | |---|---|---|---|---| | 1 | $10 | 100 | Initial OBV | 0 | | 2 | $11 | 150 | 0 + 150 | 150 | | 3 | $10 | 120 | 150 - 120 | 30 | | 4 | $12 | 200 | 30 + 200 | 230 | | 5 | $11 | 80 | 230 - 80 | 150 |

As you can see, the OBV line fluctuates based on whether the price closes higher or lower than the previous day, weighted by the volume traded.

Interpreting the OBV Line

The OBV line itself is the primary visual component for interpretation. Here's how to read it:

• **Rising OBV:** A rising OBV line generally indicates that buying pressure is dominant. This suggests that volume is flowing into the security, and a price increase may follow.

• **Falling OBV:** A falling OBV line generally indicates that selling pressure is dominant. This suggests that volume is flowing out of the security, and a price decrease may follow.

• **Divergences:** These are crucial signals. Divergences occur when the price and the OBV move in opposite directions.

   * **Bullish Divergence:**  Price makes lower lows, but OBV makes higher lows. This suggests that selling pressure is weakening, and a potential price reversal to the upside is likely. The volume isn’t confirming the downward price movement, hinting at accumulation.  This is a strong signal, especially when combined with other indicators like the Relative Strength Index (RSI).

   * **Bearish Divergence:** Price makes higher highs, but OBV makes lower highs. This suggests that buying pressure is weakening, and a potential price reversal to the downside is likely.  The volume isn't confirming the upward price movement, hinting at distribution.

• **OBV Trendlines:** Similar to price charts, you can draw trendlines on the OBV line. A break of an OBV trendline can signal a change in momentum. For example, a break below a rising OBV trendline could suggest weakening buying pressure.

• **Support and Resistance:** The OBV line itself can act as support and resistance levels. Look for areas where the OBV line has previously bounced or stalled.

OBV and Price Confirmation

One of the most effective ways to use OBV is to confirm price action.

• **Price Breakout with OBV Confirmation:** If the price breaks above a resistance level *and* the OBV is also rising, this confirms the breakout and suggests that the upward move is likely to continue. The volume is supporting the price increase.

• **Price Breakdown with OBV Confirmation:** If the price breaks below a support level *and* the OBV is also falling, this confirms the breakdown and suggests that the downward move is likely to continue. The volume is supporting the price decrease.

• **Price Consolidation with OBV Divergence:** If the price is consolidating in a range, but the OBV is showing a bullish divergence, this suggests that buying pressure is building beneath the surface, and a breakout to the upside is possible.

Strengths of OBV

• **Simple to Calculate and Understand:** The calculation is straightforward, and the concept is relatively easy to grasp.
• **Early Signal Potential:** OBV can sometimes provide early warning signals of potential price reversals, as volume often changes before price.
• **Confirmation Tool:** It effectively confirms price movements and breakouts/breakdowns.
• **Identifies Accumulation and Distribution:** Helps identify periods of accumulation (buying) and distribution (selling).
• **Works Across Timeframes:** Can be used on various chart timeframes, from intraday to weekly or monthly.

Weaknesses of OBV

• **Lagging Indicator:** Like many momentum indicators, OBV is a lagging indicator, meaning it reacts to past price and volume data. It's not a predictor of future price movements, but rather a reflection of current and past trends.
• **False Signals:** OBV can generate false signals, especially in choppy or sideways markets. Divergences can occur that don't lead to actual price reversals.
• **Sensitivity to Volume Spikes:** A single day with extremely high volume can significantly impact the OBV line, potentially distorting the signal.
• **Doesn't Consider Price Magnitude:** OBV only considers whether the price went up or down, not *how much* it went up or down. A small price increase with high volume is treated the same as a large price increase with high volume.
• **Requires Volume Data:** Accurate volume data is essential for OBV to be effective. If volume data is unreliable or unavailable, the indicator will be less useful.

Combining OBV with Other Indicators

To improve the accuracy of your trading decisions, it’s crucial to combine OBV with other Technical Indicators. Here are a few examples:

• **OBV and Moving Averages:** Use a moving average on the OBV line to smooth out the fluctuations and identify longer-term trends. A crossover of the OBV line and its moving average can signal a change in momentum. Consider using a Simple Moving Average (SMA) or an Exponential Moving Average (EMA).

• **OBV and RSI:** Combining OBV with the RSI can help confirm divergences. If both indicators are showing a bullish divergence, the signal is stronger than if only one is showing it.

• **OBV and MACD:** The Moving Average Convergence Divergence (MACD) is another momentum indicator that can be used in conjunction with OBV. Look for confirmation of signals between the two indicators.

• **OBV and Volume Weighted Average Price (VWAP):** The VWAP helps determine the average price weighted by volume. Comparing OBV trends with VWAP can provide deeper insights into market sentiment.

• **OBV and Fibonacci Retracements:** Use Fibonacci retracement levels to identify potential support and resistance areas. Confirm these levels with OBV signals.

• **OBV and Candlestick Patterns:** Confirm candlestick patterns with OBV signals. For example, a bullish engulfing pattern with a rising OBV line is a strong bullish signal. Consider patterns like Doji, Hammer, and Engulfing Patterns.

• **OBV and Chart Patterns:** Confirm chart patterns like head and shoulders, triangles, and flags with OBV signals.

Advanced OBV Techniques

• **OBV Slope:** The slope of the OBV line can provide additional information. A steepening slope suggests accelerating momentum, while a flattening slope suggests decelerating momentum.

• **OBV Histogram:** Some charting platforms offer an OBV histogram, which displays the difference between the current OBV value and the previous OBV value. This can make it easier to identify changes in momentum.

• **OBV Relative Strength Index (OBV RSI):** Applying an RSI to the OBV line can help identify overbought and oversold conditions in the OBV itself.

• **Multiple OBV Lines:** Using OBV lines with different volume weighting techniques can offer a more nuanced view of volume flow.

Conclusion

OBV is a valuable tool for traders and investors looking to understand the relationship between price and volume. While it has its limitations, when used in conjunction with other Technical Analysis techniques and a sound risk management strategy, it can provide valuable insights into potential price movements. Remember to always confirm signals with other indicators and consider the overall market context before making any trading decisions. Mastering the interpretation of divergences and using OBV to confirm price action are key to unlocking its full potential. Don't rely solely on OBV; it's one piece of the puzzle in a comprehensive trading plan. Further research into Elliott Wave Theory, Japanese Candlesticks, and Support and Resistance will also significantly enhance your trading skills.

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners