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Trader's Corner

Use of the OBV Indicator; Computing My Call/Put 'Sentiment' Indicator

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NOTE ON MY TRADER'S CORNER ARTICLES:
My weekly (Wednesday) 'Trader's Corner' article is an extension of my Sat/Sun Index Trader column in that I explain the whys, wherefores and uses of the technical (analysis) principles, chart patterns, and indicators that I use in my Index Trader weekly column. Moreover, in providing explanations and how to use these principles and tools, I can update as needed my outlook and opinions on some of the major Stock Index charts [e.g., S&P 100 (OEX) and Nasdaq 100 (NDX)] and my view on them midweek.

The Index Trader is a section on the Option Investor.com web site and is NOT seen in the OI Newsletter (OIN) that is e-mailed on the weekend (Sat/Sun). There is however a 'link' to this article at the TOP of the weekend e-mailed Newsletter that will take you to my weekend Index Trader article on the OI Website.

This past Saturday, I wrote on my market outlook (still bullish, but turning cautious), the specific major Index support and resistance levels that I appear to be important technically, and an explanation of how I calculate my call to put bullish/bearish 'sentiment' indicator, which I'll also repeat below; my 11/5 Index Trader can be seen by clicking here.

OIN SUBSCRIBER QUESTION:
Can you explain how daily trade volume relates to how the trend in the Nas 100 (tracking) stock QQQQ looks or in any other stock for that matter?

RESPONSE:
It is said technically about stock volume, that for the trend to look strong technically, volume should move in the SAME direction as the trend. This is more true in individual stocks than it is in the QQQQ tracking stock for some reason. (In periods of a sideways trend, volume will tend to tend neither to increase or decrease much from day to day.)

In an up or bullish trend, daily trading volume will tend to increase (expand) on upswings and contract (fall off) during down days or periods. IF it does this, volume is 'confirming' the price trend.

In a down or bearish trend, daily trading activity tends to 'confirm' the trend direction (down) when volume tends to increase on down days and contracts or diminishes on up days.

I would add something about the price and volume relationship and make the statement above read ".. for the trend to look strong technically, 'On Balance Volume (OBV)' should move in the SAME direction as the trend.

ON BALANCE VOLUME:
On Balance Volume or OBV is an indicator that constructs a running total of volume that ADDS all the day's volume number when the close is higher than the day before and deducts all the day's volume when the close is lower than the prior trading session.

With the OBV indicator, we are not concerned about whether volume is greater than or less than another day, and are looking at the direction of the LINE; i.e., it the OBV line trending higher with an up trend or lower with a down trend (volume is 'confirming' the price trend)?

Conversely is the OBV line trending down while prices continue higher; or, lower while prices trend higher; i.e., volume is 'diverging' from the price trend and suggests that the trend may be technically weak.

I'll show some chart examples of some of these concepts.

In Google's (GOOG) chart below, you can see the parallel tendency for daily volume numbers to expand/increase when prices are going up. When prices are going sideways to lower, daily volume for GOOG tends to taper off during that period; if this stock was headed into a downtrend, volume would tend to increase.

Note that this most recent spurt higher in GOOG above was NOT accompanied by any substantial volume surge and, not surprisingly, the stock looks like it might have started a downside correction today (11/9). Note the major jump in volume on the big upside price gap of October.

In the daily chart of ExxonMobil (XON) below, periods of rising prices are followed by nothing worse than a sideways trend on balance when the stock was declining in March-May. This pattern suggests that the stock was being 'accumulated' or bought on weakness.

The period of price weakness in XOM over the past few weeks, except for the big jump in volume on the one-day, has been accompanied by volume holding steady. If the October decline was the start of any prolonged bearish trend or period, it's likely that more liquidation of the stock would have occurred which would have been suggested by RISING volume, which hasn't happened.

Use of the On Balance Volume indicator can make the volume situation more clear as to whether the volume trend is moving in tandem with the price trend or diverging from the price trend. It helps that OBV is a single line and that it is easy to see its DIRECTION (up, down or sideways) direction:

Looking at Google again, the volume trend as mostly matched the direction of the (price) trend. Sometimes, OBV tips us off to an upcoming trend reversal, even if minor. While GOOG went up strongly in Aug-Sept, OBV trended sideways to lower. A 2-week downside correction followed.

OBV stabilized and started turning up AHEAD of the last big price surge in GOOG (above). A nice tip off, as the calls were still cheap; not so after the sharp upside move that resulted in a major upside price gap.

There are times that OBV turns up, or down, ahead of the trend. In early-March the OBV line in ExxonMobil (XOM) turned down just ahead of the sharp price break. Then this indicator went basically sideways while the stock continued lower in April. This was suggesting that the stock was being bought on balance on the decline.

The best OBV 'signal' occurred during the period circled in yellow above, when OBV started trending higher in August while prices were still going sideways on balance. This allowed a period when it was advantageous to accumulated XOM calls.

BEST USE of the OBV Indicator: use WITH the daily volume BARS
I suggest applying the OBV indicator on TOP of the daily volume bars if your charting application will allow you to do that (per the QQQQ chart below). If your own charting application or one on a web site allows OBV use as a separate study, put it above or below the volume indicator.

Going back to QQQQ, which was part of the Subscriber question, use of the On Balance Volume OBV Indicator proved to be quite useful on occasion to alert us to a trend reversal at some key points. In early-July, OBV turned up ahead of the upside reversal in the Q's. Beside the approximate double top of early-Sept., a tip off on the correction that followed was the fact that the OBV line turned down just ahead of the downturn.

Again, because OBV is a directional line, it's easier to see the direction of the volume trend, in order to match it to the price trend. It is not the holy grail of indicators, but On Balance Volume is useful, especially at those times when daily volume jumps around; you need only glance at OBV to confirm the dominant trend in trading activity. It's even more useful when OBV turns up or down ahead of key (price) reversals.

OIN SUBSCRIBER QUESTION:
"Love your column.
Would you share exactly how you obtain the put to call ratio?"

RESPONSE:
Before I note the method of computation for the indicator, the indicator is shown on the bottom of the S&P 100 (OEX) chart below. The recent call/put extreme was suggesting that the OEX might be at or near a top.

The failure of OEX to pierce resistance at the previously broken up trendline has followed since the call/put extreme. However, OEX is also holding support at the prior downtrend line. The jury is still out! OEX above 565 maintains a bullish chart, whereas a fall under 560 suggests a correction is underway.

CALCULATING EXTREMES IN 'SENTIMENT':

EXTREMES IN BULLISHNESS:
I define bullishness as getting 'extreme' when any ONE day's CBOE equity options call volume is 1.9 to 2 times or more the total put volume (this figure excludes INDEX options volumes).

On a day that 1 million equities options traded on the CBOE and 500,000 puts changed hands. Dividing 1,000,000 by 500,000 equals a call to put ratio of 2.0. Call volume is divided by put volume each day. Quite simple.

EXTREMES IN BEARISHNESS:
I define bearishness as being or getting extreme when there is any one day when the daily ratio of CBOE total equities call volume to that day's put volume is 1.2 or less.

For example, a day when daily equities call volume equaled 919,301 and daily equities put volume was 819,150. 919301 divided by 819150 equaled a call/put figure (a ratio) of 1.1. Readings at or below 1.2 tend to precede bottoms, often within 1-5 trading days.

DEFINING EXTREMES:
My rule of thumb is to look for a tradable top OR tradable bottom to be reached within 1-5 trading days AFTER either 'extremes' (1.9-2.0 or more and 1.1 or less) are reached.

AFTER any such extreme, I ALSO then look for a 'confirming' sign of a trend reversal. For example, a key downside price reversal such as a sharp final spurt up followed by a close under the prior day's low, or a double bottom or top, and so on. Also, I look for whether there's an RSI overbought or oversold extreme around the time of, or after, a call/put extreme.

WHAT MARKET 'SENTIMENT' IS ALL ABOUT:
One measure of whether the market is getting overheated or, the reverse ('overdone' on the downside), is by examining the daily volume of option put volume relative to call volume; a "standard" measure of this is the study of put to call option volumes; i.e., a ratio of total put volume to call volume, including both equities and Index options and using the CBOE (Chicago Board Options Exchange) volume figures alone or for all exchanges.

My method is different in that I divide call volume by put volume to get a whole number rather than a fraction in the standard 'put/call' ratio; plus I take OUT Index volume numbers, which includes a lot of hedging, rather than more purely 'speculative' activity.

Why use Option Volume Ratios?
It has been noticed that when put volume gets quite high, such as being equal or more than to call volume, traders are getting pretty bearish. If call volume is twice or more that of put volume the market it typically approaching a bullish extreme in terms of how traders feel about the market. Traders are 'closest' to the market so to speak, day in and day out, which is why options volume is a good indicator about the market in general.

How bullish or bearish option traders are is best shown by where they are putting their money; more into calls or more into puts and what is the trend of that. There is the factor or selling calls and selling puts of course; e.g., selling puts is a bullish play. Nevertheless, the majority of option traders are betting on market direction, so call volume goes up on rally phases and put volume increases substantially in declining markets.

I've talked before about how Charles Dow, back more than a 100 years ago, observed that at significant market tops most market participants are bullish and at market lows many were shorting stocks, or they were out of the market; no options then!

Dow started writing about the idea that if there is especially heavy buying or heavy selling, the market could be nearing a trend reversal and something contrary to the trend was about to happen when everyone was heavily betting on one direction or the other for the market.

The concept of "contrary opinion" more or less started with Dow. That extremes in bullishness are bearish and bearish extremes in trading are bullish, reminds me of 'Alice in Wonderland' for its topsy-turvy ways of seeing things!

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **
 

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