On-balance volume indicator

The on-balance volume as an indicator represents an asset’s cumulative trading volume. It keeps adding volume on days when the price rises and subtracts it on the days when the price declines.

On-balance volume (OBV) is one of the popular momentum indicators used by traders to predict the price of an asset using volume numbers.

The indicator uses daily volume changes to make predictions of a bullish or bearish trend.

OBV is essentially based on the principle that if volumes are increasing sharply without a significant change in an asset’s price, then the price will eventually move upwards or downwards. Hence, this indicator mainly tries to measure buying and selling pressure in an asset.

The on-balance volume as an indicator represents an asset’s cumulative trading volume. It keeps adding volume on days when the price rises and subtracts it on the days when the price declines.

Remember that one individual quantitative value of OBV does not hold any meaning. Instead, it is the movement of OBV over time that is analysed and used for interpretation. Comparing the movement of OBV with the actual asset price over a period can also help traders forecast future price shifts. Let’s explain this in detail.

How is OBV calculated?

As mentioned earlier, OBV is a cumulative indicator. This means it is the running total of positive volume and negative volume.

Positive volume is the volume on up-days and negative volume is the volume on down days. In other words, all of the day’s volume is added when the stock price closes higher than its previous close, whereas all of the day’s volume is subtracted when the stock closes lower than its previous close.

OBV calculation begins with volume at any previous point in time – say close of the previous trading day. 

Now three situations arise:

Case 1: If the closing price of the asset is higher than the previous day’s closing price. In that scenario:

OBV = Previous OBV + Current Day’s Volume

Case 2: If the closing price of the asset is lower than the previous day’s closing price, then:

OBV = Previous OBV – Current Day’s Volume

Case 3: If the closing price of the asset is the same as the previous day’s closing price:

OBV = Previous OBV + 0

Therefore, OBV will rise over a time when trading volumes on up-days will outweigh the trading volumes on down-days. The trend of rising OBV highlights positive volume pressure that can lead to higher prices.

Similarly, OBV would fall when volume on down-days is much higher than volume on up-days, hinting at a bearish trend.

Also, if the OBV indicator makes a significant move without an accompanying move in the price of the asset, a possible trend reversal can be anticipated.

For example, if volume begins to sharply increase or decrease even as the stock price remains relatively flat, then OBV will show significant movement even as stock price is stable. This indicates that the greater amount of buying or selling is likely to result in a sharp price movement to the upside or downside in the near term.

Limitations of OBV

As is the case with other momentum indicators, the biggest drawback of OBV is that it is limited to volume data and does not consider other important factors that can affect the price movement of an asset. So, it should not be used in isolation. Rather, traders should use other indicators in combination with OBV while keeping a track of the news flow around an asset to make a more informed trading decision.

Also, OBV may give false signals in a low-volume market. It should not be relied on if trading activity is thin in the asset.

Conclusion

OBV indicator uses trading volumes and price of an asset to measure buying and selling pressure. Traders can use OBV to foresee a trend reversal in the price of an asset. However, it should be used in conjunction with other momentum indicators to get a complete and more accurate picture of the markets.