A common indicator frequently used to help clarify volume activity is “On Balance Volume” or simply OBV. Most Stock charts will highlight volume at the base as a series of bars or histograms and these simply represent the number of shares transacted in a given day. The volume bars however don’t tell you whether the activity was associated with buying pressure or selling pressure. This is when OBV is often used to help understand the associated price movement, and it is shown as a simple oscillator on the chart.
On Balance Volume is just the cumulative total of volume and is calculated like this. If today’s closing price is higher than yesterday’s closing price, then todays volume is added to the cumulative total. Conversely, if today’s closing price is lower than yesterday’s closing price, then today’s volume will be subtracted from the cumulative total. In this way by looking at the OBV oscillator you get a “running total” of volume and whether it is rising or falling.
A rising OBV means that buying “pressure” is increasing because by design it is comparing today’s closing price with yesterdays. Traditionally technical analysts would look for stocks that have a rising OBV because it suggested that the buying pressure is high and would presumably continue. This is where in my opinion, the OBV interpretation has its weakness.
Let me explain. Prices do not always rise on rising volume and this is why it is important to consider volume and price action together. Imagine a stock that everyone owned because it was perceived to be of great value. If you owned the stock, what would it take for you to sell it? More than likely you’re going to hold onto it no matter what. Of the few people who don’t own the stock, but want a piece of the action, they will have to compete in the market for any remaining shares.
Like trying to lever limpets off a boat, the few buyers will have to offer higher and higher prices to entice the “limpets” to sell. The volume of sales for the day is likely to be well down and yet we know that each sale was likely occurring at higher and higher levels. How would I know this? Simply, look at the chart and the price bar for the day. If the price opened at the same level as it closed the day before, but closed significantly higher today then it’s clear that even though there were few buyers, there was lots of conviction amongst them and the buying “pressure” was enormous. The OBV would in this case be flat and therefore misleading.
On any chart there are always three pieces of data, price, volume and time. Every known indicator is a function of that information. Understanding how those three relate to each other is what technical analysis is all about. Master them and you’ll be surprised what secrets lie beneath.