According to legendary Dow theorist, Richard Russell, volume tends to expand in the main direction of the trend, and since it’s always helpful to know the direction and strength of a trend, MoneyShow’s Tom Aspray details the nuts and bolts of a leading indicator he has relied on over the years.

Volume is one of the best tools that an investor or trader can use to tell whether money is moving into or out of a stock or ETF. Regular readers know that my favorite volume indicator is the on-balance volume (OBV) that was introduced in 1963 by Joe Granville in his book Granville’s New Key to Stock Market Profits.

As I have been using it for about 30 years, it is not surprising that I have my own way of interpreting it. It can be looked at in a very simplistic manner or it can also be analyzed in depth using trend lines and moving averages. As I discussed in an earlier trading lesson OBV: Perfect Indicator for All Markets, it can often be a very good leading indicator.

In the early 1980’s before it was a popular approach I always advocated looking at multiple time frames, initially concentrating on weekly, daily, and intra-day data. After a few years, I added in monthly data, which can be very useful for determining the major trend and can be especially helpful for longer-term investors.

In this article, I would like to explain how I apply the OBV on monthly, weekly daily and even hourly data. In addition, I want to review some of the specific OBV formations that I have found to be quite reliable in both up or down markets.

The most basic level of OBV analysis is to determine whether it is following the price behavior. In other words, in an uptrend the OBV should be keeping pace with prices or leading prices higher. In a downtrend, both the OBV and price should be making a series of lower highs and lower lows.

In some instances, you will also see the formation of bullish or bearish divergences between the OBV and prices that can alert you to important changes in trend. Of course, the longer the time frame the more important and reliable the signal will be.

In a recent Charts in Play column, I reviewed the monthly OBV analysis on the gold futures contract as it has been making new highs with prices since 2002. This is the most basic level of OBV analysis but as the gold example illustrates it can be a powerful tool.

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The first market I would like to cover is the very popular Spyder Trust (SPY), which tracks the S&P 500. The monthly chart of the Spyder Trust (SPY) above covers the period from 2009 until the present. The monthly OBV had moved above its WMA at the end of August 2009 ( not shown) and made convincing new highs with price in April 2010.

Over the next four months, the OBV tested its rising WMA before completing its bottom formation at the end of September 2010. When the OBV drops down to test its rising WMA, it identifies a good buying opportunity no matter what time frame you are using. Conversely, when the OBV rallies back to its declining WMA, it provides a good selling opportunity.

The OBV made a new high in February 2011 but as prices were making another new high in April, the OBV formed a negative divergence, line a. This made a correction likely but not an end to the major uptrend. The SPY made further new highs in May but the OBV did not and by the end of June (line 1), the OBV had dropped below its WMA.

The extent of the volatility over the next four months is evident by the wide ranges on the monthly chart. The low for SPY in October was lower than the August low but the OBV did not make a new low, forming a positive divergence, line b.

By the end of March 2012, the OBV had made it back to its declining OBV but it turned lower the following month. It was not until the end of July 2012 (line 2) that the OBV moved above its flat WMA. Though the monthly OBV is rising and above its WMA, it has not yet surpassed the highs from 2011. This will need to be watched in 2013.

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Tickers Mentioned: Tickers: SPY, IWM, NFLX