There are endless indicators an investor or trader might use in their strategy, ranging from the chandelier exit to the relative strength index, or RSI. Stock market participants often use two or more indicators in correlation in order to improve accuracy. However, an indicator that has recently attracted attention in the trading world is the on-balance volume (OBV) indicator.
Joseph Granville created the OBV indicator in 1963 and published it to the world in his book, Granville’s New Key to Stock Market Profits. Volume is the indicator’s key focal point, and Granville contended major changes in volume could forecast price movements.
In the book, he stated signals generated by the OBV indicator are “a spring being wound tightly.” If volume increases significantly with no major change in price, then the indicator hints that a large upward or downward movement in price will follow.
What Is the On-Balance Volume (OBV) Indicator in Stocks?
There are three rules that must be followed when calculating OBV. But first, let’s get familiar with some symbols: T= Today’s closing price, Y= Yesterday’s closing price.
The rules are:
- If T>Y, then current OBV = previous OBV + today’s volume.
- If T<Y, then current OBV = previous OBV – today’s volume.
- If T=Y, then: current OBV = previous OBV.
The actual figure of the OBV is not the important part of the indicator. Rather, analyzing the cumulative flow of volume that is pinpointed to a set starting date is how to read the OBV indicator. Once there are enough data points, a user can plot a line to view the trend of the indicator.
The slope of the OBV line should trend in the same direction as a stock’s price. For example, if both price and the OBV slope are moving upward, then the trend of higher prices should continue, and vice-versa. When the two lines start to trend in opposite directions, this is called a divergence. If price is moving upwards, while the OBV is sloping downwards, the price is likely to fall, and vice-versa.
The indicator seeks to provide insight on the activity of large institutional investors. If institutions are buying into a name that retail participants are selling, volume may become elevated while price remains stable.
Eventually, the price may move higher as institutional buying outpaces retail selling. When retail investors notice this, they may move back into the stock and unknowingly become exit liquidity for the institutional investors.
On the date of publication, Eddie Pan did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
