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Getting Reacquainted with an Old Friend

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Have you ever realized that you've let weeks or months go by without touching base with an old friend? Have you been mulling over what restaurant would be best for dinner and realized it's been months since you last frequented one of your favorites? Recently, when thinking about market breadth, I realized that months had gone by since I had last checked in on one of my favorite indicators: on-balance volume or OBV.

OBV has been used since 1963 when Joe Granville first introduced this indicator. He wanted to measure whether volume flow is positive or negative.

The calculation for OBV proves simple. If the underlying closes up, the period's volume is added to the previous OBV. If the underlying closes down, the period's volume is subtracted.

After a brief background on OBV, let's take a step back about six or seven weeks, when this article was first roughed out, and see what OBV was showing us, then see if it's proven predictive in any way. First comes the background on OBV, a type of breadth indicator.

On May 11, McMillan commented in his weekly update, "Breadth is a somewhat schizophrenic indicator though--easily swinging back and forth between buy and sell signals--so we tend to use it only as a confirming signal." McMillan was talking about breadth as measured by advancers minus decliners. The way McMillan uses breadth indicators, only as a confirming signal, contrasts with the way that some use OBV. Technicians consider OBV to be a leading indicator, on the theory that volume tends to lead price.

Let's look at a bullish case to see how OBV works. Some technicians look for instances when OBV rises while price still consolidates near recent lows. Such action might be revealing that buyers are seeking that security. Traders who spot such action can then prepare a trading or investing plan for that underlying, waiting for price to follow the money flow.

Note: Remember that these first charts do not reflect current prices.

Annotated Weekly Chart of GM:

Although most technicians consider OBV to be a leading indicator, revealing in this case that smart money is beginning to buy GM, it can be dangerous to enter on an OBV signal alone. Smart money can often afford to begin accumulating while price is still on the way down, stepping into positions, while most of us retail traders can't. We often don't have the account size, patience or time frame to do so. Let the OBV guide you in making a trading plan. Let price trigger that plan.

Don't worry about the absolute value of the OBV, technicians would caution you. Look instead at the trend. If it's heading higher, following a rising trendline of its own, that signifies that volume tends to be higher on days when price is rising than it is on days when price is dropping. That's what you want to see if you're in or considering a bullish play.

Although it's not always mentioned as a way to use OBV, watching for divergences can also be useful when devising trading plans or planning adjustments to a trade you've already entered.

Annotated Weekly Chart of GM:

A trader or investor who noticed the bearish price/OBV divergence could have prepared a trading plan, placing stops at the account-appropriate place in case that GM's price did fall. Those who wanted to short the stock could also prepare a trading plan.

Now that we know something about how OBV works, it's time for that look back to what OBV might have been showing about six or seven weeks ago. During the last weeks of April and first weeks of May, many were noticing negative breadth patterns on many major U.S. indices. Were those negative patterns showing up on the OBV?

Unfortunately, it's not easy to watch OBV on the major indices. However, it is possible to use proxies such as the SPY, QQQQ and DIA. About six or seven weeks ago, all of them were showing price/OBV relationships similar to the one shown below.

Annotated Weekly Chart of the SPY:

OBV is so extreme that if it weren't for the caution in all technical analysis texts that it's not the absolute number but the trend that's important, I would have been tempted to call this worrisome on a contrarian note.

As this article was first roughed out on May 12, OBV on the daily SPY chart was showing a tendency to flatten, however, with the fast line approaching the slow line. With the weekly price candlestick on many indices a doji at the top of a steep climb, it would have been a good idea to dial down to the daily chart often. The daily chart's OBV might have been quicker to react, quicker to reveal anything that might have looked worrisome to those in bullish plays or exciting to those anticipating new bearish ones.

Annotated Daily Chart of the SPY:

Now let's look forward, to see what has happened to that daily chart since May 12. Did OBV prove helpful or predictive?

Annotated Daily Chart of the SPY:

This chart seemingly proves McMillan's point for him, with OBV churning as price does, too. If OBV had been showing only higher highs, still trending higher, I would predict an upside breakout of the volatile consolidation that we've been seeing since the middle of May. Conversely, if OBV had been showing only lower lows, trending lower, I'd lean toward a downside resolution. However, OBV isn't trending: it's chopping out a megaphone shape.

A closer look at the daily chart reveals that OBV has provided some useful information for swing traders, at least, even as it has chopped out a megaphone shape.

Annotated Daily Chart of the OBV:

The OBV signals have proven more jittery than is typical since that mid-May period. Traders who first noticed the tendency to flatten and then saw the first bearish crossovers of the blue line over the orange were soon alerted that they might not get much mileage out of their bearish plays, since bearish crossovers were soon followed by bullish ones.

What about the weekly chart?

Annotated Weekly Chart of the SPY:

Is OBV predictive here? We don't know that yet, but it's time to formulate plans in case it is. Check in every now and then with this old friend to see whether he was telling a tall tale or right on the money.

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