Watch our video below on how to use the on balance volume study aka OBV.
This week I wanted to discuss the On Balance Volume Study (The OBV) in thinkorswim (TOS). Joe Granville introduced the OBV in his 1963 book, Granville's New Key to Stock Market Profits. It was one of the first indicators to measure positive and negative volume flow.
Volume flow is a great way to identify money moving into a stock or out of a stock. Chartists can look for divergences between the on balance volume study and price to predict price movements or use the on balance volume to confirm price trends.
The OBV is a study that was developed to point out when divergence occurred between price action and volume. Granville suggested in his book that moves in volume come before moves in price.
Pause here to think this through: A small candle (perhaps a spinning top or long wick doji) may offer a small amount of positive volume (which would only move the OBV line a small distance) while the candle before and the candle after may be large body and present lots of negative volume which would move the OBV on a much longer distance.
Granville noted that the on balance volume study would often move before prices. He discussed volume pressure in his book, suggesting that a rising on balance volume would signal buying pressure “pushing up” on prices that were flat or moving down and that a falling OBV would signal selling pressure “pushing down” on prices that are flat or moving upwards.
Using trend lines, these differences are easier to spot. With the OBV, volume is added or subtracted at the close of the candle so the trend lines should always be drawn against the close of the candle body, not against the wicks or the open of the candle.
These differences in direction are called divergence and before we go any further, we will look at the word divergence to get a better understanding of the meaning behind it. On Investopedia, there is a great definition of divergence. What is Divergence?
The divergence occurs when the stock price and volume move in opposite directions or when the price move is not as great as the volume on a chart. Divergence can be an indication of an imminent positive or negative price move. Divergence is one of the most complex signals and one that can give less experienced investors false signals.
The most common way to identify divergence with the on balance volume study is by using trendlines to distinguish when:
Here is an example of trend lines showing divergence between the OBV and price action.
On balance volume is a very simple indicator with very powerful signals but finding those signals can take some time. By adding a few changes to the regular OBV study found in TOS, we can identify when those signals are present and snap some trend lines onto the chart for confirmation.
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Look at the changes made to the on balance volume study. First, I have added a Simple Moving Average to the OBV Study, to identify when the on balance volume is above or below average.
Next, I have added a red dot for bearish divergence and a green dot for bullish divergence. On the green candle highlighted below, the candle closed much higher than the previous candle close while the OBV signaled a very small volume gain.
This low volume confirmation signaled to the trader that new money was not supporting this higher move in price. I also have added labels and alerts which pop up when the OBV is giving signals a trader should pay attention to.
If the on balance volume crosses above or below the OBV Moving Average, or if there is Positive or Negative Divergence. As a final touch, I have added a change to price candles when there is a divergence between the on balance volume study and price action.
Recommendations: Once a divergence dot appears, snap a flat line onto the on balance volume study and the chart. Draw out trend lines looking for confirmation of the signal. Spotting divergence is difficult, even for experienced traders. The Red and Green Dots will help signal that something is ‘off’ and a second look should be given.
In the picture below, the OBV crosses below the Moving Average a few bars sooner than price crosses down below its moving average. Also, notice that the OBV continues to remain sloped down; staying below the moving average and giving no indication of a reversal.
While price action showed indecision and crosses above the moving average before crossing back below the average and moving lower. The OBV would keep a trader out of this trade, perhaps avoiding the price crossover signal.
The on balance volume study is a great technical tool to confirm volume and price for buying and selling pressure. This momentum indicator can be a great help when placing trades.