Introduction to On Balance Volume (OBV)
On Balance Volume (OBV) is a momentum-based technical indicator that measures buying and selling pressure as a cumulative volume indicator. Developed by Joseph Granville in 1963, OBV is based on the premise that volume precedes price movements. Traders use OBV to confirm trends, identify potential reversals, and predict breakouts before they occur.
Understanding the On Balance Volume Indicator
OBV operates on a simple principle: it adds volume on up days and subtracts volume on down days. The assumption behind this is that when volume increases without significant price movement, smart money (institutional investors) is accumulating assets before a major price movement.
OBV Calculation
The OBV is calculated as follows:
- If the closing price is higher than the previous day’s closing price, then:OBV = Previous OBV + Current Volume
- If the closing price is lower than the previous day’s closing price, then:OBV = Previous OBV – Current Volume
- If the closing price is the same as the previous day’s closing price, then:OBV remains unchanged
This results in a cumulative line that moves up and down with changes in volume flow.
How to Use OBV in Trading
1. Trend Confirmation
One of the primary uses of OBV is to confirm price trends. When OBV and price move in the same direction, it confirms the strength of the current trend.
Bullish Confirmation
If the price is rising and OBV is also increasing, this confirms that buying pressure is supporting the price increase, suggesting a continuation of the uptrend.
Bearish Confirmation
If the price is falling and OBV is also decreasing, this indicates that selling pressure is supporting the downtrend, making it more likely to continue.
2. Divergence Trading
Divergence between OBV and price can signal potential reversals.
Bullish Divergence
- When the price makes a lower low, but OBV forms a higher low, it suggests that selling pressure is weakening.
- This can be an early indication that the downtrend may reverse into an uptrend.
Bearish Divergence
- When the price makes a higher high, but OBV forms a lower high, it suggests that buying pressure is weakening.
- This can be an early signal that the uptrend may reverse into a downtrend.
3. Breakout Confirmation
OBV can also help confirm breakouts from support and resistance levels.
- If the price breaks above resistance and OBV rises significantly, it confirms a strong breakout.
- If the price breaks below support and OBV falls sharply, it signals a genuine bearish breakdown.
4. Trendline Analysis with OBV
Drawing trendlines on the OBV chart can help identify trend shifts before they appear in price action.
- A break above an OBV downtrend line may indicate the start of an uptrend.
- A break below an OBV uptrend line may signal the start of a downtrend.
Trading Strategies Using OBV
1. OBV and Moving Averages Strategy
Combining OBV with moving averages can improve accuracy in trend-following strategies.
How It Works:
- Use a 50-day moving average (MA) on OBV.
- When OBV crosses above its MA, it suggests increasing buying pressure and a bullish signal.
- When OBV crosses below its MA, it indicates increasing selling pressure and a bearish signal.
Example:
A trader using OBV with a 50-day MA might buy a stock when OBV crosses above its MA while the price is breaking a resistance level.
2. OBV with RSI (Relative Strength Index)
Using OBV alongside RSI can help confirm overbought and oversold conditions.
How It Works:
- When RSI is below 30 (oversold) and OBV starts rising, it signals a potential buy.
- When RSI is above 70 (overbought) and OBV starts falling, it suggests a potential sell.
3. OBV and Support-Resistance Strategy
Traders can use OBV to confirm breakout or breakdown trades at key levels.
How It Works:
- Identify strong support and resistance levels.
- If OBV rises sharply before a resistance breakout, it confirms strength and signals a buy.
- If OBV drops sharply before breaking support, it confirms weakness and signals a short.
4. OBV and Price Action Strategy
Price action combined with OBV gives traders deeper insights into trend movements.
How It Works:
- Identify price patterns like triangles, flags, or head and shoulders.
- If OBV confirms the pattern’s breakout direction, take a position in that direction.
Example:
If a stock forms a bullish flag pattern and OBV is rising, it increases the probability of an upward breakout.
5. OBV Scalping Strategy
Short-term traders can use OBV for quick scalp trades.
How It Works:
- Set a short time frame (e.g., 5-minute or 15-minute chart).
- Enter trades when OBV rises sharply on an up move or falls sharply on a down move.
- Exit trades quickly when volume momentum slows.
6. OBV with MACD Crossover Strategy
MACD (Moving Average Convergence Divergence) combined with OBV provides strong confirmation signals.
How It Works:
- Buy when MACD crosses bullish (signal line crossover) and OBV is increasing.
- Sell when MACD crosses bearish and OBV is declining.
Real-World Example of OBV Trading
Case Study: Apple Inc. (AAPL) Stock
- Trend Confirmation:
- Price of AAPL rises while OBV steadily increases, confirming a strong uptrend.
- Divergence Signal:
- Price makes a new high, but OBV shows a lower high, signaling weakening momentum before a correction.
- Breakout Confirmation:
- AAPL breaks resistance at $150, and OBV rises sharply, confirming a valid breakout and strong buying pressure.
Final Thoughts
OBV is a powerful tool for confirming trends, spotting divergences, and predicting breakouts. While it is highly effective, it should not be used in isolation. Combining OBV with other technical indicators like RSI, MACD, and moving averages can enhance accuracy and provide stronger trading signals. Practicing OBV-based strategies in a demo environment before live trading can help traders build confidence in their approach.
By incorporating OBV into your trading strategy, you can gain a deeper understanding of market trends and make more informed trading decisions. Whether you’re a short-term trader or a long-term investor, OBV can be a valuable addition to your technical analysis toolkit.