On-Balance Volume (OBV) Indicator – Trading Strategy and Tips

The On-Balance Volume is a technical analysis tool that depicts the volume associated with the price movement of an asset. It enumerates the combined volume of an asset traded as the price rises and falls, giving a more concise picture of the momentum driving such price changes.

In this article, we take you on a journey toward unraveling the mechanisms and interpretation of the On-Balance Volume. We also show how to incorporate it into your trading strategies. Finally, we highlighted the benefits and limitations derived from the indicator.

What is the On-Balance Volume (OBV) Indicator?

The On-Balance Volume was built on a fundamental principle: volume often precedes price movement. John Granville developed the indicator and introduced it in his book “Granville’s New Key to Stock Market Profits” in 1963.

Essentially, the OBV indicator seeks to quantify the cumulative buying and selling pressure behind an asset based on its volume changes.

By adding and subtracting the relative performance of volume for a period to or from its previous volume, the indicator draws up a chart that often rises and falls with price action. This chart provides insights into the strengths of trends and the sustainability of the trends, helping traders predict future price movements.

Since volume and price trends are highly correlated, the OBV indicator can help traders know when is the right to enter or exit a position. Normally, when there’s a strong trend in the market, the volume rises. Conversely, when the market is trading sideways, there’s low volume, and traders can either wait for a new trend to begin, or utilize the range trading strategy.

How Does the On-Balance Volume Indicator Work?

Let us take, for instance, the number of fruits picked up from a store increases at a particular price level. There is a tendency for this market dynamics to drive up the price of the fruits. However, sellers may force the price down when people start picking fewer fruits from the store at the new price. This is the concept behind the OBV indicator, helping traders decide what next step to take, but how exactly?

Firstly, the indicator considers an asset’s price-associated volume for a start period. Going forward, it adds the volume of a new period to the last if the price goes up, subtracts the latest volume from the previous if the price falls, or adds nothing if the price stays the same. In other words, when the price of an asset increases on a given day and the volume also increases, the OBV indicator rises. Conversely, when the price falls as volume increases, the OBV falls too. The cumulative volume generated over the set period is plotted as a line chart of the indicator.

The formula for the On Balance Volume is as follows.

OBV = OBVPrev + V if CPn is greater than CPn-1

OBV = OBVPrev if CPn is equal to CPn-1

OBV = OBVPrev – V  if CPn is less than CPn-1

Where:

OBV = On Balance Volume

OBVPrev= Previous On Balance Volume

CPn = Current Closing Price

CPn-1 = Previous Closing Price

However, the value readings of this indicator are optional as they change based on the reference start period. Instead, traders often look for the direction of the indicator’s trendlines. The relationship that the indicator forms between price movement and volume is crucial for understanding market sentiment. With these, market concepts such as price trend continuation, trend reversals, and divergence become observable. We will discuss more on these concepts in the next section.

How to Use The On-Balance Volume Indicator in Trading

A primary method to use the On Balance Volume is to confirm ongoing trends. A rise in the OBV alongside a surge in price action tells that buying pressing is increasing, further making a case for the continuing bullish trend.

Similarly, when the OBV falls alongside a decrease in price action, it indicates that selling pressure is intensifying, strengthening the bearish trend signal. Traders can then look for a short price retracement and enter a trade to join the ongoing trend.

In another scenario, traders can look for divergence on the indicator. This points strongly to what price action could do shortly. Divergence occurs when the price of an asset moves in the opposite direction of the OBV. For instance, if the price is making higher highs and the OBV is making lower highs, it could indicate a weakening buying pressure and a potential trend reversal. This is a case of a bearish divergence, as seen in the chart below.

On the other hand, when the price is making lower lows while the OBV makes a higher low, it suggests a weakening selling pressure and a potential price reversal to the uptrend. This is a Bullish divergence. Divergence serves as an early warning sign for changes in market direction, enabling traders to make prompt decisions.

It’s also a bullish divergence when the price makes a higher low while the indicator makes a lower low. And similarly, it is a bearish divergence when the price makes a lower high while the indicator makes a higher high.

Finally, you can trade the On Balance Volume with moving averages. The idea is to pull up a moving average unto the Indicators charts to obtain signals when there is a cross-over between them. For instance, if we pull up a 20 EMA onto the OBV chart, then a cross of the OBV above the EMA indicates a buy signal, and a cross of the OBV below the EMA signifies a sell.

On-Balance Volume Indicator Trading Strategy Tutorial

Let us consider a step-by-step procedure for trading financial assets with the On Balance Volume. In this example, we look at a strategy of trading the OBV with a moving average.

Here, we use the 20-period Exponential Moving Average (EMA). Then we look for a crossover between the EMA and the OBV. When the OBV crosses above the EMA, we go long after confirmation with a secondary indicator. Otherwise, we sell.

On Balance Volume Indicator with Moving Average

The OBV is our primary indicator for placing trades when it crosses with the 20 EMA. However, to filter out the choppiness of the signals, we confirm our trade with a separate indicator, the Bollinger Bands. Now let us consider the following steps to use the On Balance Volume with an Exponential Moving Average of 20.

1. Launch your OBV indicator below the price chart and a 20-period EMA on the OBV chart.

2. Pull up any other indicator that works for confirmation. For this example, we use the Bollinger Bands.

3. Look for when the OBV crosses below the 20 EMA and confirm if your price action breaks out of the upper Bollinger and closes back in. Enter a short position.

Otherwise, enter a buy trade if the OBV crosses above the 20 EMA and price action breaks out of the lower Bollinger and closes back in.

4. Set your stop loss below the spike of the last candle for a buy position or above the previous candle for a sell position.

5. Take profit when price action tests the opposite edge of the Bollinger.

On-Balance Volume Indicator – Pros and Cons

The On Balance Volume is quite functional for identifying new trends to get in early enough and detecting trend reversals when buying and selling pressure decreases. However, combining the indicator with other indicators that help filter out false signals proves more effective. Indeed, the OBV is characterized by certain benefits and limitations, as obtainable in many other indicators. We discuss these benefits and limitations below.

Benefits of Using the On-Balance Volume Indicator:

The OBV indicator quickly points you to trading opportunities by identifying existing and new trends in the market. These opportunities can sometimes be crucial to expanding your profit margins.

It also helps that the OBV works well with other technical indicators. This way, you can easily find a way to fit it into your trading strategy. Another advantage is that it can be applied to various asset classes and on various timeframes. Also, the simplicity with which it can be used makes it a favorite among professionals and novices alike.

Limitations of the On-Balance Volume Indicator

Always consider using the OBV indicator with other technical indicators, as it may serve poorly due to some limitations.

For one, the On Balance Volume indicator is at its worst in a ranging market. It gives false signals when the market doesn’t have a definite upward or downward direction. As a result, you would need to rely on other indicators to filter out its many false signals in the ranging markets.

Key Takeaways

Frequently Asked Questions About Trading the OBV Indicator

The following are some of the most frequently asked questions about the On-Balance Volume.

What is an On Balance Volume trend?

The On Balance Volume trend refers to the direction in which the OBV line moves. If the OBV line rises, it indicates an increasing buying pressure, helping to confirm a potential or existing uptrend. Conversely, a falling OBV line indicates increasing selling pressure, signifying a price action movement in the downtrend. In addition, the trend direction is more prominent than the actual value readings of the OBV.

What are the best settings for the On Balance Volume indicator?

The best settings for the On Balance Volume depend mainly on user preferences. However, the default setting is typically a 14-period calculation. Many traders apply this default setting. Traders can experiment with different timeframes to suit their trading style and preferences.

Is the On Balance Volume indicator available on Metatrader 4/5?

The OBV indicator is available on MT4 and MT5 platforms. Traders can access this indicator within the platform’s technical analysis tools and apply it to their charts to aid their trading decisions.