As technical indicators go, on-balance volume grows whiskery with age. In the hyper culture of the frequent trader, the newest and most complicated indicator may appear best. OBV (on-balance volume) sounds simple-minded when compared to new strategies such as singular spectrum analysis, but whiskered as the OBV may be, its logic remains clear.
First introduced by Joe Granville in 1963, OBV measures positive and negative volume flow. The direction of the flow proves more important than the indicator's numerical value. OBV rises when volume is heaviest on up days and falls when volume is heaviest on down days, and it should normally rise and fall in accordance with price action.
Annotated Daily Chart of Dell:
To determine OBV's value, add the day's volume to the previous day's OBV on up days and subtract the day's volume from the previous day's OBV on down days. For this purpose, an "up" day is defined as one on which the closing price is higher than the previous day's close, and a "down" day is one on which the close is lower than the previous day's. If the closing price is the same as the previous day's close, volume is neither added nor subtracted. The OBV would remain at the previous day's level. These calculations are simple enough to be performed with a pencil and a scrap sheet of paper, although most charting services take care of the calculations for you.
Simple doesn't equate to antiquated, however. As the Dell example above illustrated, divergences in price and OBV action alert traders that the action of funds, institutions and traders with deep pockets do not support the current price action. Divergences can pinpoint times when wise money distributes stock into each rally or accumulates stock on each dip.
Annotated Daily Chart of Dell:
In this case, bullish price/OBV divergence occurred. OBV's higher low indicated that not as much volume was flowing into days when prices closed lower than it had on the first swing low. Logic holds again.
Traders might intuitively discount the other type of price/OBV divergence at swing lows: times when OBV swings to a lower low while price dips to a higher low. Discounting that type of divergence might be a mistake.
Annotated Daily Chart of Boeing:
Any price/OBV divergence at a swing high should make traders suspicious of the rally. Any divergence at a swing low should prompt traders to suspect that accumulation is occurring.
Volume tends to precede price action, so OBV may not be a good market-timing tool. As with any type of divergence, it offers a warning, allowing bulls and bears to take steps to protect profits and plan new entries the opposite direction. Those new entries should await price action that confirms that such entries are valid.
The previous charts employed examples of big-cap stocks. There's a reason for that. OBV may not be as reliable an indicator for a thinly traded stock vulnerable to pump-and-dump activities, although it does occasionally serve up a warning, even on those.
Annotated 15-Minute Chart of MGAM:
OBV may be one of the whiskered old fellows of technical indicators, but he's still got something to say. Newer and more complicated indicators can pinpoint divergences, too, but the value in this one is that it's derived from volume rather than price, so perhaps presents a stronger corroboration that the price action is not sustainable than might be obtained from an indicator derived from price action. OBV may be one of the old guys, but when he warns, pay attention.