4 July 2020
What is Volume?
Before defining what on-balance volume is and how it works, we need to know what volume is. The volume is the total number of securities traded during a given period for each price range. This means that the volume determines the strength of a trend during a determined time. This allows investors to study the behavior of the trend.
Usually, investors study the trend through a graph. There, the time is on the abscissa axis (horizontal), and the stock price is on the ordinate axis (vertical). A deep study of the volume graphic will help the investor to know when it is the ideal moment to buy or hold the assets.
Why is Volume Important?
The volume is important for a trend to continue. If the volume is high, the prices will keep a high trend. But if the volume is low, this would suggest a drop in the trend, and there could be a consolidation or even a shift in price. Moreover, the volume is a key aspect for analysts. It validates technical signals for buying or selling generated by supply and demand.
The volume is an absolute number of assets. This means that it expresses all the transactions made in a frame of time. Yet, it does not show when the securities are being sold or bought. To predict price movements, investors use different indicators known as On-Balance-Volume.
What is On-Balance-Volume?
The on-balance volume is one of the most known technical trading momentum indicators. It is used to predict changes in stock prices, and the volume flow is the principal protagonist.
Joseph Granville created and developed the first OBV metric in 1963. He explained how it would work in his book Granville’s New Key to Stock Market Profits. The OBV metric is based on a cumulative total volume. Finally, it predicts when major moves will take place in the market according to the volume flow.
How Does On-Balance-Volume Work?
Every day, the total volume receives a positive or negative value. This depends solely on the price fluctuation. If the close result is high, the volume will receive positive value. If the close result is low, it will receive a negative value.
The volume determines the selling and buying pressure. That is if the volume decreases when the price is up, it means that the selling pressure has increased. If the volume increases while the price is down, the buying pressure will increase. This is what the OBV predicts.
How is OBV calculated?
Usually, OBV is calculated with a simple formula:
- OBV: current on-balance volume level.
- OBVprev: previous on-balance volume level.
- Volume: latest trading volume amount.
- Close: Closing of the current period.
- Closeprev: Closing of the previous period.
The investor has to keep this formula in mind in order to calculate the OBV. These are the rules to apply the OBV formula:
- If today’s price is higher than yesterday’s, Current OBV = OBVprev + today’s volume).
- If today’s price is lower than yesterday’s, (Current OBV = OBVprev – today’s volume).
- If today’s price equals yesterday’s, current OBV does not change (Current OBV= OBVprev).
How to Interpret the OBV
Granted, that equation might look a little confusing. We will try to explain it in simpler terms.
If the OBV moves in the same direction as the trend, it is a sign that the trend will remain the same. If the indicator goes against the trend, this means that the trend is fading and could reverse.
The current value of the OBV can lose its relevance. For this reason, analysts and investors find it more relevant to determine and analyze the trend. To do so, they use the past data of the OBV to predict future divergences in the trend.
The OBV indicator can be supplemented with others to correct false signals. Also, it makes it easier to understand volume and price changes. It is a convenient option for those investors who are starting to trade.