Traders employ different technical indicators to assess supply and demand mechanisms and understand the market psychology. Since indicators can generate reliable trading signals, they help investors to find profitable trading opportunities. However, technical indicators don’t guarantee market success. Therefore, traders must also learn effective risk management strategies. In this piece, we discuss the OBV indicator in detail.
What Is OBV Indicator?
On balance volume (OBV) is a technical indicator used to link price and volume while trading stocks. The indicator measures selling and buying pressure utilizing volume and help clients to predict the price movements of the underlying security. No doubt that volume has a vital influence on the stock market, and it represents the attention of market players and aids in price speculation. That’s why people prefer using the OBV indicator.
History of OBV Indicator
Understanding the need for comprehensive volume structure research that gives more trading buffer, especially in turbulent markets, Joshep Granville invented the OBV in 1963. He believed volume has a more substantial influence on markets than price change.
Granville further explained that if volume grew or fell drastically without affecting the price of the issue, the cost would eventually go higher or lower.
What Does OBV Indicator Tell You?
The OBV hypothesis distinguishes between savvy institutional investors and less skilled retail traders. The volume appears to increase as institutions, including investment funds and trading houses, start buying the stake of ordinary investors available for sale. Over time, volume tends to drive the prices upward. On the other hand, the reverse occurs as institutions sell their positions and ordinary investors re-accumulate.
Despite being drawn on the price chart and quantified statistically, OBV is irrelevant. Although the indication is cumulative, the time interval remains fixed. Therefore the actual numerical value of OBV is dependent on the start date. So instead, traders and analysts focus on the OBV line’s slope over time.
Analysts typically track institutional investors using the OBV Indicator. To illustrate purchasing opportunities against prevalent trends, they use volume and price divergences as a metaphor for connecting smart money and the diverse masses. For example, institutional investors may bid up an asset’s price before selling it.
Formula to calculate OBV
OBV calculation becomes pretty simple after understanding the relation between two recurring trading days’ closing prices.
Please note that today’s price may be lower, greater, or the same as yesterday’s volume depending on the price connection. We have the following three equations for the OBV in all three cases:
1) OBV = Yesterday’s OBV – Today’s volume
2) OBV = Yesterday’s OBV + Today’s volume
3) OBV = Yesterday’s OBV = Today’s volume
Example of OBV Indicator
Consider a hypothetical daily share price and volume. Let’s understand it using the following numbers. We’ll convert them to OBV changes.
First Day = $10.00 per share; 10,000 shares
Second Day = $10.10; volume = 12,000
Third Day = $10.05; volume = 14,000
Fourth Day = $10.15; volume = 8,000
Fifth Day = $10.12; volume = 9,000
Since the first and the second day are days with price spikes, we add these traded volumes to the OBV. On the other hand, the prices fell down on the third and fifth days, so the volume is subtracted from the cumulative OBV figure. The OBV on the fifth day may look like this;
First Day’s OBV equals to 0.
Second’s Day OBV = 12,000 (0 + 12,000)
Third’s Day OBV = -2,000 (12,000 – 14,000)
Fourth’s Day OBV = 6,000 (-2,000 + 8,000)
Fifth’s Day OBV = -3,000 (6,000 – 9,000)
This calculation shows that OBV can be negative or positive. The premise is that as the share price rises, OBV rises proportionally. OBV falls by the share volume each day when the share price falls.
Difference between OBV and Distribution/Accumulation line
Being momentum indicators, both OBV and the accumulation line rely on volume to forecast the smart money movement. However, the similarities cease there. It is computed by adding up the volume on each up day and subtracting it on the down days.
Not to mention, the accumulation/distribution line is calculated differently from the OBV. The Acc/Dist is calculated by taking the current price’s position relative to its previous trading range and multiplying it by the volume of that time.
How to set up an OBV Chart?
The OBV is a volume-momentum indicator that requires no changes. The OBV automatically modifies its values depending on automated calculations.
You may adjust the indication line’s color or thickness to improve the user experience. For instance, if the default color of the line is green and you like simple candlestick charts, you can modify the line’s color.
You may also move the OBV’s box on your chart to better organize your workspace for trading.
When putting up the OBV on your chart, avoid using time frames less than 4 hrs because they have significant volatility and might create extra noise.
How to trade using the OBV indicator?
Clients can use the On Balance Volume (OBV) indicator in three ways.
Method 1: To validate a trend continuance, traders can employ the OBV indicator.
Method 2: When the OBV and price trend are in opposition, clients can use the OBV indicator anticipating a price reversal.
Method 3: The OBV indicator can indicate the early breakout, precisely if the price moves in a range.
On Balance Volume (OBV) Confirmation
OBV confirmation enables you to discover a price trend. For example, when changes in volume and price are positively correlated, it can signal a high probability confirmation of a trend. In this circumstance, the rise in volume would lead the price to surge, while a volume decrease may result in price decline.
- Confirmation of OBV on Stock Charts
The OBV indicator confirms that a rising trend will continue in the price of an asset class like stock. In this case, the OBV indicator validates the uptrend by increasing.
- Confirmation of OBV in Crypto charts
In this case, OBV corroborated the bitcoin price trend. As evident, the bitcoin price reached a new ATH (all-time high) due to incremental volume flow.
Divergence of On Balance Volume (OBV) Indicator
The divergence occurs in an uptrend when the price prints a higher high (H-H) but OBV prints a lower high (LH). On the other hand, a downtrend involves price printing a lower-low (LL) and OBV printing a higher-low (HL).
- Divergence of OBV indicator in Stock Charts
When looking at the share price of Apple, it appears that the price has made a new high, and the trend is upward. On the other hand, the OBV indicator shows a lower high, which implies bulls have lost power and selling pressure has started building up.
- Divergence of OBV indicator in Crypto Charts
When a price approaches its support/resistance levels, it responds violently. In such a scenario, bitcoin’s price rose, OBV volume decreased. In actuality, OBV revealed bitcoin’s price reversal before it dropped. In other words, when the price rose, bulls lost power, and bears seized control.
OBV breakout
Breakout trading is no longer as simple, and many traders fall into bull/bear traps. OBV can assist traders in differentiating a messy breakthrough from a real one. Just remember, If the price breaks a resistance level, the volume should increase.
On the other hand, If the price breaks a support level, it should lose volume.
- Breakout of OBV indicator in Stock Charts
In this case, Tesla shares range on a certain price level with firm support. Observing the volume movement in this area, the OBV verified the price breakout to the downside before the price plummeted. It can also predict a price breakthrough before it occurs. In this situation, bears control the cost and escalate selling pressure, causing it to crash.
- Breakout of OBV Indicator in Crypto Charts
Not to mention, the price swings of cryptocurrencies are unique. The bitcoin price fluctuates too much, causing traders to lose focus.
OBV suggested a price break out just ahead of the price surged in this case. In other words, holding a position for an extended period at this price level would be beneficial with a close stop loss.
Limitations of OBV Indicator
Like all other indicators, OBV can lead you to false interpretation. Therefore, you should have realistic expectations while using it. Do not forget to take precautions before employing it.
In extremely liquid markets like Forex (e.g. EUR/USD), the OBV might be useless in determining whether a signal is correct or incorrect. Essentially, there are numerous buyers and sellers for each price when there is enough market liquidity. So, more volume doesn’t always mean more money. OBV indicator is more useful in other markets such as stock or crypto.
Market volatility can also significantly impact the performance of the OBV indicator. It might mislead you after price breakouts. Since the OBV indicator cumulates volume, even a single candlestick volume may significantly impact.
In such a scenario, it becomes difficult to ascertain If buyers/sellers can manage price after hitting new levels or they’ve lost control. In other words, you may use the OBV indicator to validate price movement before a breakout. However, making a move based on the OBV indicator after the breakout wouldn’t be wise. Instead, it would help if you use other technical indicators combined with the OBV to confirm the price action.
Notably, low volatility always makes lower periods noisier. But again, OBV can produce false indications in smaller time frames. So avoid using OBV as a sole indicator while trading lower time scales.
Pros and Cons of OBV Indicator
Like other indicators, the OBV indicator also comes with some pros and cons listed below.
Pros
- OBV is one of the leading indicators that reasonably predict significant market changes
- Clients can learn the computation, plotting, and interpreting signals in a few trading sessions. Of course, you’ll need to practice identifying institutional from retail volume. Not to mention, some indications and order flow can be fraudulent. Overall, the OBV is one of the most user-friendly indicators.
- The OBV indicator works in all types of markets, including stocks, bonds, futures, forex, and cryptocurrencies. However, the market must have related exchange volume and evaluate more extended time-frames.
- Among all volume indicators, traders use the OBV the most. The indicator is generally found to be preferred among day traders due to being a real-time momentum indicator. Experts who wish to add insights based on volumes to their analyses also find it pretty useful.
Cons
- Dealing desk brokers can increase volume by issuing bogus orders and canceling them before their execution. A surge in trade volume might throw off the indicator. Due to a fake trend, it may fool you into hurrying your trading choice.
- It generates signals but doesn’t tell much details. The trader can’t study the reasons that led to a specific indication. Irrespective of bucks or pennies, the OBV indicator adds or subtracts/eliminates the same volume independent of price. As a result, we deem the indicator unconvincing for price analysis. So each produced signal requires a trader to incur risk.
- While this is true for most indicators, it is especially true for the OBV. Because volume analysis is not definitive, traders typically use additional indicators to seek breakouts, such as adding Moving Average lines (MA) to the OBV.
Conclusion
In the present times, with the increase in accessibility of trading tools to almost everyone with a device and internet connection, more and more participants are involving in the market. Therefore, both the volatility and volume keep increasing day by day. Although the OBV works in small and large volume markets, the indicator might not cater to turbulent market conditions. Price surges or downfalls, flash crashes, and transaction cancellations destabilize prices and impact the trading volume. It can push the OBV beyond boundaries and promote false signal production. The OBV indicator might be helpful when combined with other indications. So, it can assist you in spotting trend reversals, divergences, or confirmations, enhancing your trading techniques. However, in today’s economy, it isn’t worth utilizing alone. Undoubtedly, employing OBV as your only signal could end up as a catastrophe. If you really find an edge with this indicator alone, well done. If not, it’s generally best to use it as a confirmation and create your own strategy, backtest and then live test to validate the statistics you have collected in your backtesting.
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Frequently Asked Questions (FAQs)
What does a negative OBV suggest?
A negative OBV suggests two things; the price is low today than yesterday, and the traded volume is more significant today than yesterday. It generally indicates tremendous selling pressure followed by a probable bearish pattern.
How accurately does the OBV Indicator work?
The OBV indicator works accurately in a steady market, specifically when you apply OBV to larger time frames, and there is low market volatility. However, it is better to avoid depending solely on its indications. The OBV works best when combined with other indicators.