On Balance Volume

As an alternative to looking at volume bars and trying to gauge the buying or selling pressure from that, technical analysts can also use an indicator called the On Balance Volume or OBV. This was developed nearly 50 years ago by Granville, and can be used to confirm the current trend, or by diverging from the price action can suggest a reversal.

Again computers come to our aid in calculating this indicator, as it requires daily addition or subtraction. Depending on whether the price is higher or lower for the day, the day’s volume is added or subtracted from a running total. The total itself depends on how far back you chart, so is not important, but the direction of the OBV is what counts. It should be moving in the direction of the current price trend. If the OBV moves in a different direction, this is called a divergence and signals that the trend may be failing.

Here’s the same chart with the OBV below. Note that with some charting packages you can overlay the OBV on the prices which makes any difference in direction very obvious.

Now the OBV has an obvious failing, in that whether the price is ten pounds or a penny above the previous price, all volume will be added, and if below, it will all be subtracted. You may not want it to assign all the day’s trading volume one way or the other, if the margin is not large. So other volume indicators have been developed which try and correct for this.

The Demand Index (DI) calculates two values, called Buying Pressure and Selling Pressure, and calculates the DI value from these. If the Buying Pressure is more than the Selling Pressure, DI is greater than zero, which suggests that prices are moving higher. If the other way around, DI is calculated to be negative, or less than zero, which is associated with a downtrend. Again, if the indicator is different from what the price chart is showing, it suggests that something is amiss, and there may be a reversal.

If you trade futures you may also come across the Herrick Payoff Index (HPI) which is calculated to include changes in open interest. This indicator uses price, volume, and open interest combined together to determine whether money is flowing into or out of the commodity or underlying.

The idea of these indicator variations is to better display whether the heavier volume is on the bullish or bearish side. The OBV does a fairly good job, and the refinements can fine tune the numbers for a better performance.

With futures the indicators are based on the previous day’s information, because of the way that the market works – this can affect how well they work, depending on the volatility. That’s not the only issue with futures, as there are different contracts available with different expiration dates – the indicators are based on the total volume, not the volume for each individual contract. A further issue is that rapidly moving futures contracts can run into limits, as they are not allowed to change more than a certain amount each day – this typically results in light trading, which can distort the volume indicators. If you trade futures, you need to bear these shortcomings in mind, but nonetheless you can get useful information from volume analysis.

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