The On Balance Volume indicator (OBV) is a cumulative indicator similar to the Advance-Decline Line that weighs buying versus selling pressure by adding volume on up days and subtracting volume on down days. Similar to the AD line, it is not so much the overall number that is important as this varies depending on the start date, but that the movement of the OBV confirms movements in the price of the security. This can be used to confirm trends as well as identify divergences which signal that the price is susceptible to a reversal.
The premise behind this indicator is that volume can often precede moves in price as well as confirm moves in the price. Gains or losses on heavy volume are seen as being strong while gains or losses on low volume are viewed as weak and less likely to be sustained. The OBV rises when volume on up days is higher than volume on down days, signalling positive volume pressures which are a bullish sign. The opposite is also true, that when the OBV line is falling, volume on down days is greater than volume on up days highlighting negative volume pressures which are seen as a bearish sign.
Put simply, the OBV line is the cumulative total of positive and negative volume changes, with positive volume being when the price closes higher for the day and negative volume being when the price closes lower for the day. The calculation is as follows:
When the closing price is higher than the prior close:
OBV = Previous OBV + Current days volume
When the closing price is lower than the prior close:
OBV = Previous OBV – Current days volume
When the closing price is equal to the prior close:
OBV = Previous OBV
The first chart below highlights the OBV indicator, the top pane shows the price of EBAY with days where the close is higher than the previous close is black and days where the close is lower than the previous close is red to make this easy to identify. The middle pane simply represents the volume traded on a specific day, and the bottom pane represents the OBV indicator.
In this case we can use the OBV line to confirm the price movements, we can see that the price breaks to a new high in July on higher volume. The new high of the 27th of July at $31.79 is also confirmed by a new high on the OBV line at 9,318m (remember the OBV line number is not important, more that its movements confirm the movements in price). On the 8th of September the price then moves to a new high of $32.81 which coincides with a new high on the OBV line at 9,358m. We can say that the price has moved higher on stronger volume showing no signs of becoming exhausted and therefore is more likely to continue that reverse.
We can also use the OBV to identify both bullish and bearish divergences. A bullish momentum divergence is where the price moves to a new low but the OBV line forms a higher low, signalling that declines are occurring on lighter volume with a lack of conviction in moving lower and therefore at risk of a reversal. The inverse is bearish momentum divergence where the price moves to a new high while the OBV line forms a lower high, signalling the price is moving higher on lower volume showing a lack of strength highlighting momentum is fading and the price is at risk of a reversal.
The second chart below once again shows EBAY with clear bearish momentum divergence. On November the 6th the price reaches a new high of $29.69 with an OBV reading of 9,047m before moving to a new high on December 1st of $29.83 however this new high coincides with the formation of a lower high on the OBV line of 9,011m. Following the confirmation of this bearish momentum divergence that suggests gains are becoming exhausted, we can see that from early December the price trends lower strongly all the way to the low in February at $21.51.
Overall the OBV is a useful indicator to confirm movements in price and identify potential reversals. As always this indicator should be used with further analysis to confirm signals
