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Published On: Mon, Feb 11th, 2013

Strategies based on the ‘On-Balance-Volume Indicator’

If you need to compare volume flows and price for any asset over a selected time-period, then you could use the ‘On-Balance-Volume’ (OBV) indicator to perform this task. The OBV was invented by Joe Granville in 1962 when he issued his complete OBV philosophy in his publication “How to read the Stock Market”. You will find that the OBV is regarded as possibly the most revered momentum indicator and functions using the inter-dependences of the price, volume and momentum of an asset.

Basically, you need to understand that if the price of an asset records a higher daily close than its prior reading, then the OBV regards all of that day’s trading as up-volume. In contrast, if price ends the day by posting a lower daily value, then that day’s trading is deemed to be down-volume. As such, the OBV main-line is created by the cumulative sum of all these negative and positive volume values.

 on value base indicator 1

You can detect these concepts in the above diagram. You need to appreciate that the OBV may be predicting a potential price reversal when its readings alter direction as Granville discovered during his extensive research. You can identify this effect in the middle of the above diagram when the OBV starts to rise signaling the end of the current bear channel.

Very importantly, the price of an asset will most often start to track the OBV after its readings alters direction. Consequently, the OBV is very useful at identifying the birth of trends. For example, if OBV begins to post a sequence of higher lows and peaks, then you should consider instigating a new long position using the applicable asset. Alternatively, if OBV starts to record a series of descending lows and tops, then you assess this performance as an alert to sell.

In addition, you can identify if quality trades are developing when the readings of the OBV commence diverging from price because the OBV concentrates on tracking the trends of assets. You should also note that Granville advised that if OBV starts producing declining values within a bullish trend, then a market top could be forming as buying pressure begins to wane. Under such circumstance, you should not anticipate price action to continue to rise for much longer as a price reversal could occur shortly.

Granville also instructed a similar sequence of events for bearish trends except you need to kept watch for the OBV to start generating a sequence of rising values. In addition, he advised that his OBV will produce its best performance in assisting you in identifying weakening trends when it is used with the 20-period moving average. You will then be able to detect such events more readily by observing everytime this moving average crosses over the OBV line. You should appreciate that the OBV is considered to be one of the simplest momentum indicators to deploy.

Should you witness divergences between the reading of the OBV and price, then you should expect that a price reversal could happen shortly. In addition, if you detect the OBV altering direction after following the price of an asset for an extended time period, then you need to consider such a development as a signal to activate a new position.

Many investors use the OBV to help confirm the recommendations of their breakout strategies. This is because the OBV has acquired a good reputation at detecting when price is about to change direction. A major reason why breakout strategies are so favored by traders is that they produce opportunities to initiate new positions at the birth of new trends. These locations are very valuable to detect because you will then be able to instigate new trades with great profit potential but exhibiting minor risk exposure. The next diagram illustrates an example.

 on value base indicator 2

Breakouts are generated after price pierces either support or resistance levels of a consolidation box. In the above diagram, price breaks above resistance to create a new bullish trend producing an excellent buying opportunity. However, instead of opening a new position immediately, you could consult the OBV indicator. If this tool is also displaying readings that are now rising in value, then you will have attained addition vindication for activating a new long trade.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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