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The On Balance Volume (OBV) Indicator

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The On Balance Volume or 'OBV' indicator is something useful to keep with your stock charts. This indicator will occasionally alert you to 'accumulation' or 'distribution' of a stock a bit ahead of where you will see obvious upside or downside chart reversals

OIN SUBSCRIBER QUESTION:

I see that you display a volume indicator with the QQQQ chart in you weekly index wrap up, but I havent noticed you commenting about on balance volume. I mostly trade options on individual stocks and keep an eye on volume. Is this other one something useful to me also?

RESPONSE:

Yes, the On Balance Volume or 'OBV' indicator can be quite useful to keep with your stock charts. It will also occasionally alert you to 'accumulation' or 'distribution' of a stock a bit ahead of where you will see obvious upside or downside chart reversals. I like to chart OBV on top of my daily volume bars. Some charting software will force OBV to be put in a separate (chart) window, which is ok too.

The way that daily volume is plotted, when you select 'volume' as an indicator, is to display volume as a histogram or as vertical bars that show the volume total for that day (as read from the right hand numerical volume scale).

On Balance Volume or OBV is a another type of volume-related technical study or formula. An indicator being of course any mathematical calculation that is applied to a financial instrument's price and/or volume information.

To see what OBV looks like, I'll start with a daily chart of Cisco Systems (CSCO), which has long been a good tech bellwether and now will be more so since it's been added to the Dow 30 (INDU), replacing General Motors (GM). In fact the recent gap up move is no doubt related to CSCO being bought to better replicate INDU in stock portfolios. My current charts are as of the (6/3) Tuesday close.

Starting with CSCO will also be useful to show an outstanding bullish OBV/price divergence. On Balance Volume keeps a cumulative running volume figure that adds ALL the volume on an up day and subtracts ALL the trading volume on down day. If there is more trading volume on up days then there is on down days, OBV rises.

OBV provided an early and ongoing indication of sustained buying interest in CSCO in the initial months of this year. The OBV line was rising in January and February on balance while prices were trending lower basically. This divergence between price action and the On Balance Volume indicator was a strong clue that the stock was under accumulation and being bought on weakness. The best way to accumulate a stock (on weakness) that has good reason to rise later!

There was buying 'on balance' in CSCO, but not so much that any of the daily volume bars 'spiked' up dramatically. This is typical of institutional/fund buying. Professional money managers tend to accumulate stocks gradually and it is in fact a necessity for them, as their buying could really drive the stock up fast as they might have a few million shares to buy or accumulate in total.

If you study the CSCO chart above you can spot a bearish price/OBV divergence in August, as OBV is in a downward trend, while the stock is basically trading sideways. This bearish divergence suggested distribution in the stock as shares were being quietly sold 'on balance', foretelling the substantial decline the stock was to see after September.

You don't often see bullish or bearish divergences in the Nas 100 tracking stock, QQQQ, but when you do there is large profit potential in getting in on the side of the accumulation or distribution. This will typically be ahead of a rally or decline when the options are more fairly priced.

I had an example in some of my saved chart snapshots of a bullish divergence in QQQQ, back when the stock traded as 3-letter symbol 'QQQ'. The next chart shows the V-type bottom pattern that developed in QQQQ. All well and good and the bull price move was 'confirmed' when the stock broke out above the line of resistance. However, if you were JUST following volume, it was showing a flat sideways type trend with no volume spikes that would suggest strong bullish interest.

HOWEVER, when you drop down to my next chart and look at OBV, you'll see a tremendous tip off to a 'rising' volume trend suggesting accumulation.

OBV HISTORY & CONSTRUCTION:

OBV uses daily stock trading volume for its construction and was devised by Joe Granville, a legendary market analyst who was especially well known in the 1960s through the 1980's. (Joe was still writing a market letter into the 90's I believe but he didn't have the following he once had.)

Granville was mildly famous as a very colorful guy who, at times, seemed to be more of a showman than an analyst and market advisor. However, his market knowledge was through and his insights often profound. One such insight of Granville furthered Charles Dow's concept that volume would typically INCREASE in the direction of the dominant trend. On balance volume or OBV as it's popularly known, provided some further assessment of this principle and enhanced volume analysis quite significantly.

To construct the OBV indicator, a running total of volume is kept. Assume we started with a stock that traded a million shares on day 1. This is a neutral starting point as we have to start somewhere. If the stock closes higher the next day and trades 750,000 shares, day 2's volume figure is added to the first day and assigned a positive number because our running total is a positive number. OBV on day 2 is +1,750,000.

OBV would be a negative number if our example stock closed lower on day 2, on 1,500,000 shares: OBV would be -500,000.

Going back to the example: on day 3 the hypothetical stock closed lower on 500,000 shares and we subtract that day's volume from our cumulative OBV total: on day 3, OBV is +1,250,000. When the stock is unchanged in price on day 4, we leave OBV unchanged at +1,250,000.

This calculation process continues on into the future. If we graph the points, the resulting line will start moving upward or downward and will typically follow the direction of the price trend of the stock for which OBV is being calculated. Sometimes however, OBV will lead the market and start trending higher or lower, contrary to the dominant price trend as was seen in my first example in CSCO.

We are primarily concerned with the DIRECTION of OBV; i.e., is the (OBV) line moving UP or DOWN? If the direction is up, the OBV line is bullish, as there is more volume on up days than on days when the stock price is down. A falling OBV line is typically bearish, as more stock is being traded on down days than on up days. If both price and OBV are moving up together, it is a bullish sign portending higher prices. If both price and OBV are moving down together, this is a bearish indication for still lower prices ahead.

However and as already noted, if prices move higher during a period of time when OBV lags or moves lower, this is a bearish divergence indicating diminishing buying activity and warns of a possible top or trend reversal.

Conversely, of course, if prices are moving lower but OBV is trending higher, this is a bullish divergence.

With the chart of S&P bellwether General Electric (GE) seen below, there is first a bearish divergence highlighted where prices are moving higher into August, whereas OBV is trending lower, suggesting some smart money or money managers 'distributing' the stock to other willing buyers.

It's useful to point out here that standard volume analysis related to daily volume is still quite useful in suggesting a selling climax. This was seen when GE went under $7 briefly on a huge final wave of selling as seen on the huge 1-day jump in volume. From that day on, the OBV line turned up just ahead of the rebound in prices. The combination of the huge spike in daily trading volume coupled with the turn UP in the OBV line, along with stabilization of prices, offered a tremendous buying opportunity. A DOUBLE in the stock price was to follow in just over two months!

With my next and last chart, that of Google (GOOG), our current favorite search engine, price action AND the OBV line moved in tandem from the November low, which is the way it most commonly is in stocks.

However, there was a good additional buying opportunity in calls when GOOG dipped to the $300 area in March, during which the OBV line remained in a fairly steady uptrend. This type action suggested that some panic selling went on but which was met by continued steady accumulation of the stock. Sail on Google!


GOOD TRADING SUCCESS!

Leigh Stevens

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