On-balance volume (OBV) is a proven-effective leading indicator that allows traders to spot turning points and valid signals across a wide variety of markets and time frames.
For the majority of technical analysts, volume plays an important role. Unfortunately, simply comparing one day’s volume to a three-month average will not tell you much about whether money is flowing in or out of a particular market or stock.
In the late 1970’s, my father gave me a book by Joseph Granville titled Granville's New Strategy of Daily Stock Market Timing for Maximum Profit. A few years later, I found Granville’s on-balance volume (OBV) on Compu Trac, one of the earliest technical analysis software programs. I was quickly hooked on the OBV. From the following examples, as well as my daily Charts in Play column, I think you will see why it is my favorite indicator for all markets.
Joe developed the OBV as a way to determine whether the smart money was buying or selling. It is calculated by keeping a running total of the volume figures and then adding in the volume if the close was higher than the previous period, or subtracting the volume if the closing price was lower.
If you are doing this in a spreadsheet, such as Excel, the starting volume can be arbitrary, as it is the pattern of the OBV—not the absolute number—that is important. When viewed on a monthly or weekly basis, this can be very useful in identifying major trends.
From the start, I analyzed the OBV in the same way that I would analyze a price chart. I used trend lines, moving averages, and support/resistance analysis to determine whether the OBV was positive or negative.
Divergence analysis was always quite important, though divergences are not always observed at every important turning point. Like my early work on Welles Wilder’s Relative Strength Index (RSI), it was critical to use divergence analysis on multiple time frames in order to generate valid signals.
In May 1985, my analysis of the OBV on the major currencies was instrumental in helping me identify major bottoms in currencies like the Deutsche mark (DMK) and Swiss franc (CHF), and therefore, the top in the US dollar (USD). At the time, most of the leading economists were expecting the dollar to remain strong for a few years. The dollar had bottomed in November 1980 with the election of Ronald Reagan.
In a May 21, 1985 appearance on the Financial News Network, a precursor to CNBC, I discussed a chart very similar to the one above of the Deutsche mark futures contract traded on the CME. In my early adaptation of the OBV, I had also added a 21-period weighted moving average (WMA) of the OBV, which is plotted in green.
The weekly chart shows that the DMK was in a well-established downtrend (line a) starting in 1982, as it was falling in value against the US dollar. In 1984, the decline accelerated, as it fell 25% to a low of 0.2881, or 3.47 DMK per USD. By comparison, in early 1984, it was 2.5 DMK per USD.
During this decline, the OBV rallied several times to its declining weighted moving average. Then in March 1985, the OBV moved above its weighted moving average and broke its downtrend, line c. The WMA flattened out over the next six weeks before starting to rise.
On several attempts, the OBV was unable break through resistance (line d). With the OBV now above its rising weighted moving average and with confirming bullish signals in the analysis of the CHF and British pound (GBP), it suggested these currencies had bottomed out. The daily technical studies had been positive on the currencies for several months, and this was another negative for the dollar.
The OBV overcame its resistance, line d, on July 5, 1985 (line a). One week later, the DMK also broke through its corresponding resistance, line d. This is one of the reasons I find the OBV to be such a valuable indicator, as it often leads prices by one or more periods. Obviously, this can make the risk/reward on new positions much more favorable.
The DMK tested its downtrend (line a) in August and had a sharp, three-week pullback. During this time, the OBV was much stronger, as it held well above its rising weighted moving average.
In late September, the G5 nations got together over a weekend at the Plaza Hotel in New York and agreed to devalue the dollar. As you can see on the above chart, the DMK futures gapped higher and accelerated to the upside, as there was concerted intervention to lower the dollar. By early 1988, the DMK had more than doubled.
NEXT: Applying OBV Analysis Across Other Markets
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