According to the basic theory of volume, as developed by Charles Dow, volume should rise in the direction of the trend which basically implies that during an uptrend, the volume must rise along with the rising price and in a downtrend the volume must rise when the price goes down.
This rising volume confirms the quality of the trend.
With the passage of time, as more and more research came into the subject, the theory of On Balance Volume (OBV) was developed.
What is On Balance Volume (OBV)?
According to this theory, the volume is correlated with the change in price.
On Balance Volume (OBV) actually measures buying and selling pressure on a cumulative basis which subtracts volume on down days and adds volume on up days.
On Balance Volume was developed by Joe Granville and it is one of the first indicators to measure positive and negative volume flow.
People often use OBV to confirm price trend and also look for divergence between price and OBV.
On Balance Volume (OBV) Calculation
If today’s closing price is higher than yesterday’s closing price, then yesterday’s volume should be added to today’s volume and the total volume should be called On Balance Volume (OBV) for today.
If today’s closing price is lower than yesterday’s, then yesterday’s volume should be subtracted from today’s volume and the net total would be called as today’s OBV.
However, if today’s close is equal to yesterday’s close, then yesterday’s volume should not be touched and whatever OBV we had yesterday, it would remain unchanged for today.
We are not concerned with the absolute figure of daily On Balance Volume, rather what we are concerned about is overall direction of the OBV line.
The OBV line is simply a running total of positive and negative volume.
During an uptrend On Balance Volume will follow the price direction and will keep on making a higher top and higher bottom.
Hence both charts i.e. price chart and OBV chart will almost look identical.
As long as both charts move in the same fashion, the trend is said to be perfectly up i.e. volume is supporting the rise in price.
On the other hand, during a downtrend, OBV should make a lower top and lower bottom in the same style as price and it confirms that volume is supporting the downtrend and it is perfectly intact.
A time will come when price and OBV will fail to respond to each other. It may take place in any of the following forms-
1. Non-confirmation of uptrend
Here the price will make a new higher top but On Balance Volume will fail to make a new higher top. This is the first sign of trouble in an uptrend.
It shows that although the price is rising and making a higher top but volume fails to maintain that.
It indicates that rise in price is not been supported by the rise in volume.
This is called a non-confirmation and such type of non-confirmation do and can occur at the end of an uptrend.
2. Non-confirmation of downtrend
During a downtrend, price and volume both are expected to go down in a same fashion i.e. lower top and lower bottom.
At times we will find that volume and price both are not moving in tandem i.e. price has broken the last bottom but volume could not break.
It shows that price has broken with the lesser volume.
This is the point of trouble for the downtrend because the volume is no more supporting the price fall. This is called non-confirmation. This type of confirmation occurs at the end of bear market.
3. Advanced breakout
Another important and interesting factor of On Balance Volume is an advanced breakout.
As price and volume keep on rising together, there seems to be no problem but a time will come where we will see that price could not breach the previous top, but OBV line has breached the previous top. This is called an advanced breakout.
It shows that although the price has gone up marginally volume generation is so high that OBV has made an advanced breakout.
This is the signal which tells us that price will also cross the previous top. In fact, a non-confirmation is a matter of weakness whereas advanced breakout is a matter of strength.
4. Advanced breakdown
In a downtrend, Price and On Balance Volume, both are expected to move in the same fashion where both will make lower tops and lower bottoms.
But at times price will fail to break the previous bottom whereas On Balance Volume will break the previous bottom. This is called advanced breakdown.
An advanced breakdown indicates that price will also break the bottom.
This is a matter of weakness on the part of the price.
When On Balance Volume and price both follow the same direction, regardless of the trend, we can draw a trend line in price as well as in volume to watch pattern similarities.
Moreover, OBV should always be used in the daily chart in correlation with the closing chart.
Learn more about OBV in NSE Academy Certified Technical Analysis course for both beginners and advanced candidate.
To make better trades, you may combine it other indicators like Stochastic for better confirmation.
Let’s take an example to understand it better.
You may confirm the advanced breakout with that of positive divergence of Stochastic, to place your trade for the upside.
On the other hand, you may combine negative divergence with the non-confirmation, to bet on the downside price movement.
Also Read: Slow Stochastic Explained
Take care and keep learning!