INDICATORS
On-Balance Volume
by Stuart Evens
What do technicians look at in order to qualify the significance
of a trend? One key element is volume, in that high volume in a trend indicates
that large players may be involved. The theory goes that large traders
are better informed, so the trend is likely to continue. How can you track
volume? Does a volume-based indicator help the analyst and trader? Take
a look.
One of the better-known technical indicators to track
volume is the on-balance volume (OBV). The Obv line is simply a
running sum calculated by adding or subtracting the security's daily volume
from the previous day's OBV value, depending on whether the security's
closing price was up or down for the day. The OBV line is usually plotted
as a line above or below the price bar graph of the security (Figure 1).
Two popular uses of this indicator is to watch for confirmation of the
price trend by the OBV line, indicating that the volume is increasing in
the direction of the trend, and forewarning of a trend reversal by the
divergence between the direction of the OBV line and the price trend. Let's
look at the initial method and theory.
FIGURE 1: TOTAL RENAL CARE. This common layout of price
bars, OBV line, and volume bars for Total Renal Care shows the interrelationships
between each of these data. Note the effect that increased volume has on
the magnitude of change, and that net price change only determines the
direction of the line.
OBV PHILOSPOHY
OBV creator Joseph Granville first presented the concept of OBV in Granville's
New Key To Stock Market Profits. In developing this tool, Granville
started with the premise that market participants are divided into smart
money entities and the general public. He assumed that the smart money
was able to accumulate stock at lower prices compared with that of the
public based on their having better information.
During a bull market, Granville theorized, smart money initially bids
prices up and then only participates in the buying for the first-half to
two-thirds of the move. At that point, smart money players are fully invested
and are now holding for the last third of the move, planning to sell out
at the top. He opined that this is just when most of the public is starting
to notice the runup in prices and is buying the stock. This sets the stage
for the smart money, who then dumps stock to the public.
When the public finally realizes what is happening and rushes to sell,
the stock is already in a bear market and the price accelerating downward.
Granville developed his technique of tracking the OBV line to detect the
movement of smart money in the marketplace, and more important, whether
the smart money is accumulating or distributing shares. Therefore, for
the technical analyst using OBV to be successful, this phenomenon of smart
money versus the general public must be in place. The smart money needs
someone to sell to and someone to buy from. In both cases, that someone
is the uninformed individual investor. Granville's goal in developing OBV
was to provide a method to avoid trading like the uninformed investor.
A comparison can be made between OBV analysis and fundamental analysis.
William Eng, in his Technical Analysis Of Stocks, Options, & Futures,
discusses similarities between Granville's OBV and fundamental analysis.
Granville's goal was to emulate large traders and investors (smart money),
which might possess fundamental inside knowledge. Many times, the buying
or selling of the informed investor can be contrary to the more obvious
and immediately visible trend of the market and therefore can be viewed
as a contrarian technical method, Eng states.
Obv can be thought of as a technical gauge of fundamental information
that informed traders use to make their investment decisions. Once we determine,
with the help of our indicator, what direction the smart money is trading,
we can trade in the same direction and thereby benefit from the information
without actually knowing what the information is.
Ultimately, what that fundamental information is, or who the smart money
investors are, is inconsequential to the effective use of OBV. All that
is required is that price is determined by the informed smart money, and
there exists a technique that can identify stock movement resulting from
transactions made by this group. Granville presented on-balance volume
as a technique capable of doing just that.
