By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com
The on-balance volume indicator (OBV) is one of the most well-known technical indicators and it focuses on the importance of volume and how it can affect a given price and asset's momentum. The OBV indicator is used to measure the positive and negative flow of volume in a security relative to its price over time. It is a simple measure that keeps a cumulative total of volume by adding or subtracting each period's volume depending on the price movement. This measure expands on the basic volume measure by combining volume and price movement.
The idea behind this indicator is that volume precedes price movement, so if a security is seeing an increasing OBV it is a signal that volume is increasing on upward price moves. Decreases mean that the security is seeing increasing volume on down days.
The OBV is calculated by taking the total volume for the trading period and assigning it a positive or negative value depending on whether the price was up or down during the trading period. If the price traded above the previous period it is assigned a positive value while a negative value is assigned when the price has fallen during the period.
(Current Period Volume will be positive if the price increased and negative if the price fell during the period.)
The positive or negative volume total for the period is then added to the previous period's OBV. The OBV itself is simply a running total that is adjusted each period depending on the amount of volume and the direction of the security for the period.
Using the OBV
Again, the idea behind the OBV measure is that volume is thought to precede price movements. If volume is decreasing when the price of a security is rising then it is a sign of increased selling pressure, which if continued, will send the price of a security lower. The opposite is true with increasing volume on up days, which is a sign of buying pressure.
The main focus with this indicator should be on its trend. The actual value of the OBV doesn't matter as it includes a lot of past data and there is no relative comparison between the OBV of one security and another. By looking at the recent trend of OBV, one can see whether buying pressure is increasing or decreasing to either confirm an existing trend or to identify divergence.
If the OBV is moving in the same direction as the existing trend, it is a signal that the strength of the trend remains. When the OBV starts to move against the trend, it is a signal that the existing trend is weakening and may reverse.
For example, when the volume is not increasing during up days in an upward trend it is a sign that buying pressure is weakening. If buying pressure is weakening it is not likely that the upward trend is sustainable.
To help confirm a price trend reversal with the OBV a 20-period moving average of the OBV is often added. When the OBV crosses the 20-period moving average the divergence signal of a trend reversal is confirmed.
The on-balance volume measure is one of the least complex volume indicators that try to measure price and volume together. While there are more complex indicators, it is the ease of understanding and use that make this volume indicator so popular.
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