OBV Indicator: An Important Momentum Indicator for Trading — How to Use It Effectively

In trading markets, many believe that price movements need confirmation from trading volume. However, there aren’t many tools available to analyze trading activity volume. On Balance Volume (OBV) is a popular indicator among traders for tracking accumulated buying and selling pressure and helping verify the strength of price trends.

Why is trading volume important for confirming trends?

Before fully understanding OBV, we need to grasp why trading volume plays a crucial role in trading. When prices move upward, high volume indicates many buyers confirming the move. Similarly, when prices decline, high selling volume suggests many sellers driving the trend.

The importance of volume is that it tells us whether the price movement is driven by genuine buying and selling activity. Price moves without high volume are considered unstable and more prone to reversal.

What is OBV: Definition and working principle

On Balance Volume is an indicator developed by Joseph Granville in 1963, from his book Granville’s New Key to Stock Market Profits. He believed that trading volume is the driving force behind price movements.

OBV works by accumulating volume in the direction of the price. If the closing price is higher than the previous close, volume is added. If lower, volume is subtracted. If the close is unchanged, OBV remains the same.

This method allows traders to observe accumulation of buying and selling pressure. It also helps track the activity of large investors who often trade in massive volumes.

How to calculate OBV and practical examples

Calculation formula

OBV is calculated as follows:

• OBVt = OBVt-1 + Volumet : if the current closing price is higher than the previous close
• OBVt = OBVt-1 - Volumet : if the current closing price is lower than the previous close
• OBVt = OBVt-1 : if the current close equals the previous close

Where:

• OBVt = accumulated volume at current period
• OBVt-1 = accumulated volume at previous period
• Volumet = volume in the current period

Practical calculation example

Using GOOG stock data from October to November 2023:

On October 2, the closing price was $135.17 with a volume of 19,210,394 shares. Since this is the starting point, OBV for today is 19,210,394.

On October 3, the price dropped to $133.30 (lower than previous), with a volume of 19,628,736. So, OBV = 19,210,394 - 19,628,736 = -418,342.

This suggests increased selling pressure on October 3, causing the price to fall and OBV to decrease. By tracking OBV this way, traders can visualize the overall accumulation of buying and selling pressure.

How to use OBV to identify trend reversals

Using OBV to confirm trends

When prices rise and OBV also rises simultaneously, it indicates a strong uptrend. This strength comes from high trading volume supporting the price movement.

Similarly, if prices fall and OBV declines in tandem, it indicates a strong downtrend.

Using divergence to spot potential reversals

Sometimes, OBV does not confirm price movements. For example, prices make new highs, but OBV fails to do so. This is called divergence.

Divergence signals that the current trend may be weakening. Even if prices are rising, decreasing volume suggests buying pressure is waning, hinting at a possible reversal.

Combining OBV with other technical tools

OBV with Moving Averages (MA)

Moving Averages smooth out price data to identify trends and support/resistance levels.

When combining OBV with MA, traders get stronger confirmation. For example, if the price stays below the 25-period EMA and OBV is declining, it indicates a strong downtrend. If OBV stops making new lows (divergence) while the price attempts to break above EMA, it could be a buy signal.

OBV with Bollinger Bands

Bollinger Bands measure market volatility and price ranges. Combining OBV with Bollinger Bands helps pinpoint reversal points more accurately.

For instance, Microsoft stock has made new highs along with rising OBV. When OBV diverges by not making new highs while the price tests previous highs, and the price hits the upper Bollinger Band and breaks below the 20 SMA, it could be a good point to sell with a stop-loss at the previous high.

Summary

On Balance Volume (OBV) is a momentum indicator that helps traders understand the buying and selling pressure behind price movements. Using OBV alone may not be sufficient, but when combined with other tools like Moving Averages or Bollinger Bands, it significantly enhances prediction accuracy.

Learning OBV is important because it allows traders to rely not only on price trends but also on volume evidence to make better trading decisions. Proper study and application of OBV can equip traders with a more effective toolset for navigating volatile markets that change in split seconds.