What is On-Balance Volume?
On-Balance Volume (OBV) is a technical indicator that accumulates volume in either a positive or negative value depending on the price movements of the traded asset. It operates on the principle that price changes are often preceded by changes in volume. The formula for OBV is as follows:
- OBV = OBV prev + Volume （if close > close prev)
- OBV = OBV prev - Volume （if close < close prev)
- OBV = OBV prev（if close = close prev)
where:
- OBVprev is the OBV value of the previous period,
- Volume is the current period's trading volume.
How does On-Balance Volume work in a trading scenario?
OBV is employed to discern the flow of funds in a market, which can offer insight into the likelihood of price movements. Here's how it can be utilized:
1. Trend Confirmation:
- A rising OBV alongside a rising price indicates a robust upward trend, suggesting continued bullish sentiment.
- Conversely, a falling OBV alongside a falling price denotes a strong downward trend, indicating continued bearish sentiment.
2. Divergence Detection:
- If the price reaches a new high, but OBV fails to reach a new high, it may signal a bearish divergence, hinting at a potential price reversal.
- Similarly, if the price hits a new low, but OBV doesn't reach a new low, it may signify a bullish divergence, hinting at a potential upward price movement.
Example:
Suppose a stock closed at $50 yesterday with an OBV of 1,000,000. Today it closes at $51 with a volume of 200,000. The new OBV would be calculated as follows:
OBV = 1,000,000 + 200,000 = 1,200,000
This new OBV value suggests there's positive volume pressure which could lead to higher prices.
Limitation of On-Balance Volume
One of the limitations of OBV is that it doesn’t account for price-volume dynamics within the trading period; it only considers the close-to-close change. This could potentially miss intraday price and volume variations, which might offer valuable insight into the market dynamics. Moreover, OBV might not always reflect the true buying or selling pressure, especially in less liquid markets where even small trades can significantly affect the price.
