On-Balance Volume reveals market players’ strategy

While looking at volume can help investors determine where price action may be headed, imbalanced volume provides clearer signals that help investors looking to act on a trade. Volume shows crowd sentiment as price bars carve out patterns that predict a bullish or bearish outcome.

Volume supporting price action creates convergence, which adds reliability to directional signals. Opposing actions create divergence, warning that market forces are in conflict, with one side eventually taking control. Volume interpreted by an accumulation spread indicator explains this process, giving reliable signals that influence position selection and trade management.

On-balance volume (OBV), developed by Joseph Granville in the 1960s, packs enormous usage into a simple accumulation-spread tool that calculates volume up and down, adding or subtracting the result into a running subtotal.The formula generates a smooth indicator line that cuts out highs, lows and trendlines similar to price bars. Comparing relative action between price bars and OBV generates more useful signals than the green or red volume histograms commonly found at the bottom of price charts.

The OBV feedback system

OBV provides the most reliable feedback on tests of major highs and lows, making it a perfect tool for measuring the potential for breakouts and breaks. It is a simple process, comparing the indicator’s progress with price action and noting convergence or divergence relationships. This makes way for many key predictions:

OBV reaches a new high as the price tests resistance: bullish divergence, forecast that the price will break resistance and move higher, and play catch up. The price reaches a new high while OBV grinds at or below the last resistance level: bearish divergence, which predicts that the rally will stop or reverse. OBV hits new lows as price tests support: bearish divergence, forecast that price will break support and move lower, and play catch up. The price reaches a new low while OBV grinds at or above the last support level: bullish divergence, which predicts that the sell will stop or reverse. OBV matches the price action, higher or lower: bullish or bearish convergence, depending on direction.

Limit OBV analysis to major test zones on the daily chart. It is natural that conflicting relationships between price and volume develop during the course of a sideways market, reducing the indicator’s reliability between contested levels. It also does not scale well, with intraday and weekly OBV not consistently producing reliable signals.

Examples of OBV

Let’s look at two common OBV scenarios:

CME Group (CME) Steeps to 80 in June (1), Posting an OBV High Swing. It pulls back and surpasses that high in November, but OBV fails to reach its previous high (2), indicating a bearish divergence. The rally fails, giving way to a selloff that hits an 11-month low in April. The stock then enters an accumulation phase, with OBV and price simultaneously ticking higher for seven months. OBV rises to a multi-year high in September (3) while the price is still trading below the previous year’s high, creating a bullish divergence that predicts the strong December breakout.

Celgene Corporation reaches just below 90 (1) in early 2014 and enters a correction showing an extended spread. It begins to recover in April, gaining ground in a steady rise that lifts price to the previous peak in June while OBV fails to reach that level.

The stock grinds sideways for two months in a symmetrical triangle and breaks out (2) and rises to 100, but OBV continues to lag and grinds well below the high posted earlier in the year. This divergence forces the uptrend to stall and undershoot the breakout level, shaking out hopeful buyers as OBV makes a slow and steady recovery, eventually reaching a new high in November (3).

Stocks can easily break out or break down when OBV lags price action, but the divergent action waves a red flag that predicts sweeps until price turns to meet OBV or OBV turns to reach price. This testing behavior follows the second phase of the action or response-resolution cycle. This is why traders should look for OBV to match the main price before taking a risk on new breakout or breakout positions.

The Bottom Line

Off-balance volume shows the intent of market players, often before the price action generates a buy or sell signal. As a result, investors can use OBV to provide insights that can help them make trading decisions. Specifically, it is most useful as an entry filter when a security is testing a major support or resistance level.