On Balance Volume (OBV) combines price and volume to determine whether price movements are strong or are weak and lacking conviction. On Balance Volume is a simple calculation, which is given below:
- On an up day, the volume is added to the previous day's OBV
- On a down day, the volume is subtracted from the previous day's OBV.
Volume is usually interpreted as follows:
- Increasing or decreasing price accompanied by increasing volume, confirms the price trend.
- Increasing or decreasing price accompanied by decreasing volume, indicates that the price movement is weak and lacking conviction.
The On Balance Volume indicator is used mainly to confirm price trends or warn of potential price reversals because of divergences between the price and the OBV indicator. An example of an On Balance Volume divergence is given below on the price chart of Merck (MRK) stock:
High #1 to High #2
Merck stock made higher highs, but the On Balance Volume indicator made lower lows. This bearish divergence warned that price could potentially fall.
Since the On Balance Volume indicator adds volume when price closes higher than the previous day's close, the OBV indicator could be interpreted as meaning that less volume flowed into High #2 than flowed into making High #1. Less interest by buyers at High #2 signaled that the price move higher was unlikely to continue.
High #2 to High #3
Again, the price of Merck stock increased, yet the OBV indicator warned that more volume was occuring on down days than up days. This bearish divergence warned stock traders that the recent price increases were lacking strong commitment by buyers.
Low #1 to Low #2
The stock price made higher highs, generally considered a bullish signal; however, the On Balance Volume technical analysis indicator made lower lows. Volume on down days was on average larger than volume on up days.
On Balance Volume is a valuable technical analysis tool that combines both price and volume to confirm price action or warn of potential weakness or lack of conviction by buyers and sellers. An arguably better measure than the OBV that combines volume and price movement is the Chaikin Oscillator (see: Chaikin Oscillator). Also, the Money Flow Index (see: Money Flow Index) uses price and volume in a more precise and realistic manner.
