On-balance volume (OBV)

The on-balance volume (aka OBV) is a running volume indicator. If the day's close is higher than the day before, the day's volume of trades shared is added to the OBV. If it is lower, it is subtracted. In other words, the OBV goes up if the stock has an up-day and down if the stock has a down-day. Pretty simple!

The on-balance volume assumes that all shares traded during an up-day are buys that drove the price up. This demands a little bit of explanation since, last I've heard, for every buy, there is obviously a corresponding sell, so how can the trades be all considered as buys? On an up-day, demand is greater than supply, meaning buyers are willing to pay more for a security. Sellers are more than happy to oblige and sell at the higher prices. In other words, the buyers are willing to buy at higher prices but the sellers sell just because the demand is there and not because of fear. This is why you add the volume to the OBV when the stock closed higher than the day before. It is of course quite a simplification since the volume on a up day is certainly not all net buying.

Similarly, the on-balance volume assumes that all shares traded during a down-day are sells that brought the price down. This is the reason why you subtract the volume to the OBV on a down day.

What you are looking for in the OBV graph is divergence, that is, when the stock goes one way and the on-balance volume goes the other indicating a possible key reversal coming up. For example, if the stock you are screening is in a down trend and the OBV is starting to display an up trend of its own, a pivot point that would end the stock's down trend may be near.

As always with indicators, they are not always right. Actually, they are probably 50% right at best. So, it is good to know about them but do not put too much faith into them especially the rather simplistic OBV. Note that there are other more sophisticated volume indicators out there, in particular, the Chaikin's indicators but they are for you to discover (or a later post if this blog is still around).