On-Balance Volume (OBV): An Effective Leading Indicator for High-Liquidity Markets

On-Balance Volume (OBV) is a popular technical analysis indicator that is used by traders and fund managers to gain insight into buying and selling pressures in the market. In this article, we will discuss what OBV is, how it works, its advantages and limitations, and its effectiveness in different markets.

What is OBV?

OBV is a momentum-based indicator that tracks the relationship between trading volume and price movement in the market. The rationale behind OBV is that changes in volume precede changes in price, and by analyzing the volume flow, traders can identify trends and potential price movements in the market.

OBV is particularly effective in high-liquidity markets such as stocks, major commodities, and high-cap cryptocurrencies, where trading volume is high and consistent. In these markets, OBV can provide accurate signals of buying and selling pressure and help traders make informed decisions about when to enter or exit a position.

How OBV Works

OBV’s general formula is as follows:

OBV (today) = OBV (previous day) + (or -) volume_today

If today’s closing price is higher than the previous day’s closing price, addition (+) is used in the formula above.

If today’s closing price is lower than the previous day’s closing price, subtraction (-) is used in the formula above.

To illustrate this, let's take a simple example based on a period of 3 days:

Day 1: Closing price = $50, Volume = 1000

Day 2: Closing price = $55, Volume = 1500

Day 3: Closing price = $52, Volume = 2000

On Day 1, the OBV value is always set at 0.

On Day 2, OBV = 0 + 1500 = 1500; here we used addition rather than subtraction since the price increased from the previous day ($50 to $55).

On Day 3, OBV = 1500 – 2000 = -500; here we used subtraction since the price moved lower ($55 to $52).

Using this approach, we can calculate OBV values for the stock for any required period of time.

OBV values are then plotted alongside the price chart to identify divergences between the OBV line and the price line. When the OBV line diverges from the price, it can signal a potential reversal in the price trend. For example, if the price is trending upwards but the OBV line is trending downwards, it could be an early warning sign that the price trend is losing momentum and could soon reverse. This indicates a suitable time to sell.

Similarly, if the price is moving downwards and the OBV line is trending up, this signals a potential price increase around the corner. Time to long the stock.

Advantages of OBV

One of the main advantages of OBV is its simplicity. It only requires basic data on price and volume. Additionally, because OBV takes into account both price and volume, it can provide a more accurate picture of the underlying strength or weakness of a price trend.

Another advantage is that OBV can reveal potential reversals in high-liquidity markets better than many other momentum indicators.

OBV has wide applicability across markets. Most high-volume markets are fair game for the application of OBV. Besides the stock market, OBV can be useful in commodities and for high-cap cryptocurrencies on larger exchanges. In these markets, which are often characterised by volatile and unpredictable price movements, OBV can act as a powerful leading indicator.

Limitations of OBV

One limitation of OBV is that it may not be as effective in detecting trend changes in markets with significant news or events that can influence price movements. Good examples of such markets are certain commodity segments, particularly energy commodities. The major energy commodities, Oil and Gas, are significantly influenced by geopolitical events rather than by simple supply and demand projections. In such markets, OBV’s reliance on the simple price and volume dynamics might be insufficient for effective trading decisions.

Additionally, OBV may not be as effective in low liquidity markets as volume may not accurately reflect buying and selling pressures.

OBV also tends to be influenced by earnings reports and other major announcements related to the leading companies on the market. When using OBV for the likes of Tesla, Google, or Bank of America, do note the possibility of sudden spikes in volumes that are not necessarily predictive of price changes. This limitation of OBV is less of an issue with smaller stocks that don’t boast the visibility levels of the industry leaders.

Whenever you have access to a high-volume market, OBV could be a useful method to use. It often performs very well as an early indicator of trend reversals. To maximise the effectiveness of this method, however, do take into account its key limitations.