On Balance Volume (OBV)
How To Use The On Balance Volume (OBV) Indicator
Volume seems to be a pretty big deal for traders who are all always trying to judge whether a gain in stock prices is the start of a huge uptrend or just a fake out in the wrong direction. The On Balance Volume (OBV) trading indicator tries attempts a quantified approach towards volume flow in and out of the stock. It adds volume on up days and subtracts volume on down days.
What problem is the OBV trying to solve?
Many times, a stock moves upwards with very low volume, this may be seen as a weak attempt to gain due to the obvious lack of participation. What if we plotted a line which measures gain on a stock and volume to get one, clear, precise indication of a price strength. Have a look at this, example of a strong move up, on weak volumes – It resulted in a subsequent fall.
The chart below is of IndusInd Bank on the daily chart, the stock is in a sideways trend. We have marked an area of a price rise which was on falling, very low volumes which resulted in a subsequent fall.
Always remember, ‘low volume’ is a relative term, it is compared to the volume of the last few days to judge whether it is relatively high or relatively low.
When closing price is above the prior close:
Current OBV = Previous OBV + Current Volume
When closing price is below the prior close:
Current OBV = Previous OBV – Current Volume
When closing prices equals the prior close:
Current OBV = Previous OBV (no change)
The assumption is that on up days (when prices closed up) contribute towards bullish volume and down days (when prices closed down) contribute towards bearish volume. This is plotted and you can clearly see, in a way which direction the money is flowing. shouldn’t this indicator be called the money flow indicator? That name was taken already. It’s called the accumulation distribution line (ADL) and you can read about it here.
Real world use case
OBV rises when volume on up days outpaces volume on down days. OBV falls when volume on down days is stronger. One way to exploit the OBV is to use it as an accumulation indicator, by simply finding divergences between prices and the OBV indicator we can detect accumulation.
The setup: Within a downtrend (falling prices), look for the OBV NOT falling down. You will notice price rising slightly but the entire movement still largely moving down, then something interesting will happen; the OBV will ‘breakout’ and this is called a divergence. When prices are falling and the OBV breaks out is a sign of bullish times to come. Let’s have a look at this exact same situation in Tata Motors.
We can observe the same phenomena to detect distribution in stocks as well. Below is the chart of WIPRO, it seemed to be in a large sideways trend on the price charts and the OBV was within a range as well. In this case we saw that before a major fall, the OBV broke down from that range indicating large distribution and a possible sell-off. Have a look, the chart is self-explanatory.
Do you use the OBV in a different way? Share your strategy with us.
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