MY MAILBAG:

"I see you sometimes discuss the on balance volume indicator in individual stocks. How is it used in making trading decisions?"

MY RESPONSE:

The On Balance Volume (OBV) technical indicator is useful at times as a 'confirming' or 'divergent' indicator relative to price trends in individual stocks. Volume is a secondary indicator relative to PRICE. However, analysis of volume can sometimes tip us off to an upcoming change in a stock's trend. OBV is useful enough that I generally keep this indicator on my stock charts as an overlay over daily volume 'bars'.

I'll display a daily chart of General Electric (GE) to show some different ways that we could have gotten tipped off as to a change in GE's trend, including the On Balance Volume model. GE is a bellwether stock in terms of the S&P; as GE goes sometimes, so goes the market and the stock has been in a downtrend since its mid-February top. I've labeled some points on the chart to reference the RSI and OBV technical indicators.

GE went up strongly at the tail end of its December to mid-Feb. advance as highlighted by the light blue up trendline. However, you can also see that the 13-day RSI started going sideways. Besides being at an 'overbought' extreme, RSI was not confirming the final price run up, which constitutes a bearish price/RSI divergence. This is a traditional or classic price/indicator divergence.

Volume bars show daily trade volume and you can see my downtrend highlight at figure 2. As prices go up, volume normally also expands in the direction of the trend. This wasn't the case here. Prices going up on less and less volume suggests 'distribution' (selling) is going on. Volume is not 'confirming' price action. There's another technical volume indicator that suggests a bearish divergence, which is On Balance Volume or OBV, as seen with figure 3.

On Balance Volume or OBV is a type of volume indicator or 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. Technical analysis ONLY works with price and volume inputs; and sometimes, a third input of Open Interest in options and futures.

On Balance Volume involves keeping a cumulative running volume figure that adds ALL the volume on an UP day and subtracts ALL the trading volume on a DOWN day. If there is more trading volume on up days then there is on down days, the OBV line RISES. If there is more trading volume on down days than there is on up days, the OBV line falls. My next chart of American Express (AXP), shows a 'normal' pattern in that the OBV line is rising along with prices during the mid-March to July advance. Recent price action is starting to pierce AXP's internal up trendline. To date however, OBV has continuing in its uptrend, suggesting the possibility that AXP could rebound again soon.

Boeing (BA) presents an interesting bullish divergence in terms of OBV and the daily volume bars themselves. BA has been in a downtrend since its May peak in the $80 area. However, lately, the On Balance Volume line has been in an uptrend. This can ALSO be seen with the daily volume bars. Volume has picked up on the recent sideways to lower decline, suggesting possible accumulation of the stock by strong buying interests and the potential for an upside reversal ahead for Boeing. Stay tuned on that!

The daily chart of Caterpillar can be used to make some points about resistance points, including one involving CAT's OBV line. As the stock has advanced it did run into some resistance at an extension of the previously broken up trendline, most notably in the 3rd instance at the early-May top. In a related sense the OBV daily reading came back to resistance implied by the previously broken OBV up trendline. Moreover, as CAT went on to a final recent high, OBV was starting into a downtrend. What is it about the concept of On Balance Volume that causes it to work this way?

OBV HISTORY & CONSTRUCTION:

On Balance 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. He is still writing a market advisory letter but hasn't had the influence or the track record that he had 20 years ago.

When he was a analyst star, Joe Granville was also a very colorful person who, at times, seemed to be more of a showman than an analyst and market advisor. However, his market knowledge was through at one time and his insights sometimes profound. One such insight of Granville furthered Charles Dow’s concept that volume should 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 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 is now a +1,750,000.

[NOTE: 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 my hypothetical example: on day 3 the stock closed lower on 500,000 shares and we subtract that day’s volume from our cumulative OBV total: on day 3 in this example OBV is +1,250,000. When the stock is unchanged in price on day 4, OBV is also 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 following the direction of the price trend of the stock for which OBV is being calculated.

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 On Balance Volume line is 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, 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 bullish divergence, which is seen in my next chart from my historical chart database.

A divergence in technical analysis is what occurs when one component to market activity goes in one direction and another related component goes in an opposite direction. The first example of a market 'divergence' was Dow’s example of one of his averages going to a new high or low, when the other did not. Examples of price/indicator divergences seen above are another type of divergence different than in Dow's day; prices going in one direction and an indicator (based on a calculation involving price or volume) going in an opposite direction.

The example above of a bullish price/OBV divergence occurs (in a downtrend) if OBV starts trending higher (sellers become less active), a divergence that suggests being alert to an end to the downtrend. This concept goes back to the idea that volume activity can precede a change in price direction.

What I've said here is not to suggest taking action before PRICE activity confirms what OBV and volume activity has suggested. But if this occurs you can be ready to take appropriate action. In the example above, the upturn in OBV preceded a reversal of a downtrend in VRSN stock however I would not generally act on such a divergence, but would be ALERT to a potential reversal. I might however be a heavier buyer of the stock or calls on the stock than usual as soon as price action confirmed an upside reversal; e.g., by a breakout above its down trendline.

Another general thing about volume is that it is secondary indicator. Price action generally (not always) 'trumps' volume patterns. In the historical chart below, that of Abbott Labs (ABT), there is a lack of an apparent breakout move in daily volume as suggested by the down trendline on the daily volume bars as the stock moved steadily higher. The On Balance Volume line however was in a confirming up trend.

Price action was questionable however as the stock rose to resistance implied by its down trendline. Moreover, a bearish rising wedge pattern suggested an impending downside reversal. While the rising OBV was consistent with the price trend OBV did NOT indicate any bearish divergence. However, the chart had traced out a bearish rising wedge and that's what prevailed per my last chart showing ABT into 2003.

This stock example here suggests the limitations of On Balance Volume as an indicator as only occasionally does a divergent OBV suggest a trend reversal might be in the offing. Those occasional instances can be useful however for situations where ONLY a divergent volume trend suggests a potential trend reversal ahead. If so, I'd then be alert as to what was going on with the PRICE pattern that might 'confirm' OBV action.

NOTE: The bearish rising wedge pattern is explained and amplified in a prior Trader's Corner article, which can be seen by clicking on this LINK.


GOOD TRADING SUCCESS!