On balance volume enables traders to predict movements in price before they happen, but how can you use it? We’ll cover the essential details in this guide!
Traders use on balance volume (OBV) to predict security price movements ahead of time. As with other volume-centric indicators (e.g. negative volume index, money flow index), OBV will only work on markets that have exchange volume associated with them.
The on balance volume functions by maintaining a running tally on volume related to a security’s direction. Volume will be added to the total when said security’s price increases, which creates the on balance volume figure. But when the price drops, volume will be subtracted from the running total to reach the on balance volume figure.
This indicator was created in the ‘60s, based on the following idea: a down move was expected to follow a decrease in volume without an accompanying move in the security. On a similar note, if volume were to rise with no attendant increase in the security, an upward move would be expected to follow.
Every day that a share price is up, the on balance volume will rise by the share volume count, whereas it decreases by the share volume count on every day the share price is down.
On balance volume has the power to be positive and negative, oscillating from positive to negative values. As volume is additive when an asset’s price increases, the on balance volume will usually follow the market’s general trend. It will rise in uptrends and fall in downtrends.
How to Use On Balance Volume
On balance volume is intended to identify when ‘smart’ and ‘not so smart’ money are active, as with the negative volume index (NVI).
It’s believed that money which predominantly moves markets (institutional funds) tend to be most active on days of low volume, and retail traders or investors are most active on days of high volume. There’s an assumption that retail traders are usually more reactive to whipshaw market movements than bigger investors.
The driving idea behind on balance volume is that price will follow volume. Countless technical analysts believe this. So, if selling outweighs buying in a market (in a downtrend), a high number of buy orders will be needed to offset the selling and push the market in the opposite direction again.
Some of these transactions will cancel each other out, and price could consolidate without moving appreciably in either direction despite the increase in volume. But when enough buy orders have been placed to outweigh selling, that’s when price will reverse and rise again.
It’s likely that institutional traders will buy when volume is low in a flat/declining market. Volume builds and price will gradually follow when buyers manage to outbid sellers.
With price rising, retail traders will be likely to buy in the belief that the new uptrend indicates that they’re making a solid investment (instead of it typically growing more expensive). Institutional traders might start selling at this point, to lock profits in.
How On Balance Volume Trading Works
Plenty of traders using on balance volume will have more interest in its rate of change to assist in the creation of trading ideas than its value. If the on balance volume moves significantly in a particular direction, that may lend credibility to the idea that a large move in that direction in price may be imminent.
Traders looking to stay with a trend may utilize the on balance volume alongside a trend following system. For example, adding a simple moving average (such as a 50 period) to a price chart will provide traders with a basic trend indicator.
Price will be regarded as being in an uptrend if the moving average slopes upward, and anyone trading with the trend will have a bias toward long trades. Similarly, price will be considered to be in a downtrend if the moving average slopes downward. This could leave traders biased toward short selling.
Conclusion
Traders use on balance volume to understand when ‘smart’ and ‘not so smart’ money might be at their most active, with a lot of traders believing that price follows volume.
This means that if a volume (or a volume proxy indicator) rises while the response in price appears more muted, a number of traders will consider this divergence a hint that price could follow soon after. And when price moves but volume is low, some might feel this indicates that the market could be prepared to consolidate.
On balance volume capitalizes on this concept by maintaining a running tally of volume when price rises or falls. Volume (share count) will be added to the indicator on up days, while volume is subtracted from the indicator on down days.
On balance volume can be used in any type of system: price reversal or trend following/momentum. Traders who follow trends might take advantage of the on balance volume signals along with indicators that aid their identification of the trend. Similarly, traders preferring to find possible market turning points could blend the on balance volume with price reversal indicators (such as moving average crossover strategies or specific oscillator types).
