- 2000: Volume 9, No. 6 Puts & Calls: On Balance Volume: The Trend Detective

Developed by Joseph Granville, On Balance Volume (OBV) is calculated as a continuous summation of daily volume and widely used to show the accumulation and distribution action of a stock. In this calculation, there is an underlying assumption that characterizes this indicator: if the price today is higher than yesterday, then the volume is accumulation and added to the summation. Conversely, if the price today is lower than yesterday, then the volume is distribution and subtracted from the summation.

Generally speaking, it's the shape of the plot that's important while the actual value of the indicator is not as significant. The intent is to detect trends and divergences in relation to the price action. If both the OBV and the price are rising, then this is a confirmation signal and is interpreted as being bullish. If the price is rising and the plot of OBV is declining, then this is divergence and is considered a bearish signal.

The chart for Marsh & McLennan (MMC) in Figure 1 shows price, volume and the OBV summation line.

In Figure 1, the price peak in mid-September is higher than the price peak in July. The OBV peaks corresponding to those two peaks are also rising—a confirmation signal and thus bullish. The general shape of the OBV plot is also upward from June to early September.

Figure 1:

As the price continues to rise from the September peak to the price peak in October, the OBV plot is declining. This is divergence and portends a possible reversal. There is a start of a possible decline in October. Thus, the OBV plot is used in a similar was as the MACD oscillator. Divergence is important while the actual value of the plot is not. The chart for MMC in Figure 2 has additional indicators.

Figure 2:

The MACD oscillator also shows divergence. The three MACD peaks are lower as the price peaks increase. This is a three-peak divergence and is normally a strong indicator for a potential reversal. The OBV plot is confirming the MACD divergence. Here is an example where two separate indicators are in agreement. The MACD oscillator uses just price while the OBV uses just volume. Two separate data items are agreeing. The agreement is not in terms of actual value but in terms of shape of the plot.

The chart for Herman Miller (MLHR) in Figure 3 illustrates divergence as well. The price peak in early September is lower than the price peak in August. This pattern has formed a big "M" and usually is a bearish formation. However, the corresponding OBV peaks continue to be higher as the price peaks decline. This is divergence as well. There was a sharp price drop after the formation of the "M" down to the 200-day EMA line. It bounced off and rebounded back above the 20- and 40-day EMA lines. Thus, the price action confirmed the indication of the divergence between the OBV plot and the price action.

Figure 3:

There is also another confirming pattern found in this chart. The price rise from the low in July to the high in August is closely followed by the OBV plot—a confirming indication.

On Balance Volume is used as a confirming indicator by the technical analyst to help verify trends. Divergence is a very strong indication of a possible reversal and when it does occur can be helpful in determining potential entry/exit points. The analyst can then establish a strategy that may have a higher potential for success. OBV, like other technical indicators, should never be solely relied upon as an entry/exit indicator. Instead, OBV is to be used in conjunction with other indicators to establish a more firm understanding of the price pattern.

Roy Lindsay is a senior writer and technical analyst for Optionetics.com.