On-balance volume (OBV), a momentum indicator that measures positive and negative volume flow, was developed by Joseph Granville and introduced in 1963 to the technical community inside the pages of his book, "Granville's New Key to Stock Market Profits." Granville felt that volume was the driving force behind the markets, and designed OBV to project when major moves in the markets would occur. In his book, he described the increase or decrease of his indicator, setting new highs or lows, as "a spring being wound tightly."
Tutorial: Stock Oscillators and Indicators
Breaking Down the Theory
Granville went on to explain his theory by stating that when volume increased or decreased dramatically without any significant change in the issue's price, then at some point the price would "spring" upward or downward. It appears that as institutions (pension funds, investment funds and large trading houses) begin to buy into an issue that retail investors are still selling, volume increases as the price is still slightly falling or leveling out. Over a period of time, volume begins to drive the price upward and the converse then begins to take over as the institutions begin to sell their position and the retail investors begin again to accumulate their positions.
Thus, the term "smart money" begins to appear crystal clear - the institutions are buying the stock of the "average Joe" at the bottom and then selling it back to him at or near the top. You can also see how OBV can suggest major trendline turnarounds.
Here is an easy formula explaining OBV:
- If today's close is greater than yesterday's close, then today's volume is added to yesterday's OBV, and is considered up volume.
- If today's close is less than yesterday's close, then today's volume is subtracted from yesterday's OBV and it is considered down volume.
- And if today's close is equal to yesterday's close then today's OBV is equal to yesterday's OBV.
Figure 1: On-Balance Volume
Chart Created with Tradestation
It is very plain to see the dramatic change in trends in this chart of the Dow Jones Industrial Index from Dec 2000 to Oct 2001. The trends were reversed abruptly and with conviction, as the turmoil of the political and corporate environment lead the news headlines that year.