This statement is one of the cardinal beliefs held by most technicians. It first came to my attention in the late 1970s when I read Joe Granville's book New Strategy of Daily Stock Market Timing for Maximum Profit, where he wrote "stocks do not rise in price unless demand exceeds supply. Demand is measured in volume and thus volume must precede price."
In the early stages of my career, I did extensive testing of this concept and developed my own methods of interpreting the on-balance volume. It is the volume indicator in which I have the most confidence. Over the years, I have explored the OBV in more detail and last year discussed multiple time frame analysis of the OBV in The Best Volume Indicator.
In that article, I discussed the long-term bottoming and topping formations in the OBV and why the relationship of the OBV to its 21-period weighted moving average can be so important. I touched on the bullish and bearish setups that I have often observed with the OBV, which is the focus of this week's trading lesson.
Catching a major low in a stock or ETF is often difficult given the huge number of issues that are traded. I feel that tops are identified more frequently as after a long rally phase, a stock is often watched more closely. Therefore, changes in the volume and price patterns are noticed by more analysts.
In many instances, the OBV will form a positive divergence at a major low but sometimes it does not. These divergences can be explained by a transition where the demand starts to gradually exceed supply as prices reach a low point. Negative divergences at a top are a result of the fact that fewer buyers (lower volume) are pushing prices higher.
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Hewlett Packard Co. (HPQ) was one of the least-favored stocks for 2013, but turned out to be one of the winners. On the monthly chart of HPQ, I have included the OBV and volume under the candle chart along with what I call Aspray's OBV Trigger (AOT). It is a histogram plot of the spread between the OBV and its 21-period WMA.
The AOT will often trigger a buy or sell signal by flipping above or below the zero line but it can also identify long-term divergences in the volume patterns that are not evident using the OBV.
As HPQ was making its high in March 2010, the monthly OBV was also making a new high (see arrows). However, the OBV was closer to its WMA, causing the AOT to form lower highs, line b. At the end of June, the AOT first dropped below the zero line. It did reverse the following month, but then triggered a sell signal as it dropped sharply with August's high volume.
In November, the long-term uptrend in the OBV, line a, was tested before HPQ managed a weak rebound over the next two months. This presented an excellent opportunity to get out of long positions or to sell short as the OBV just rallied back to its now declining WMA (line 1). The AOT never turned positive on the rally and turned lower the following month, giving advance warning of the break in the OBV trend line support, line b.
The AOT hit its lowest level in September 2011 when HPQ traded down to $21.50. The final price low at $11.35 was not made until November of 2012. The OBV made a new low with prices but the AOT formed higher lows, line c, indicating that the selling pressure was not as strong as it was in 2011.
The daily chart gives a different perspective of the November 2012 low when the daily volume spiked to over 154 millions shares as HPQ gapped to the downside, which in hindsight, was the final stage of the panic liquidation. Six days later, the daily OBV moved back above its WMA but soon pulled back to its WMA. The AOT was above the zero line and also corrected but stayed positive. The next day, it turned higher suggesting that the pullback was over.
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The AOT peaked on December 12 as HPQ corrected for about two weeks, eventually dropping slightly below its 20-day EMA on December 28. On that day, the AOT dropped below zero but reversed to positive the following day, line 2.Those who went long before the close were rewarded as the following day, HPQ was up 5.4%.
If you are looking to buy a stock or ETF on a pullback, this approach works most of the time. Just wait until the OBV has dropped back to or below its WMA, then watch, and if the stock is higher the next day or week, you can go long especially if the volume has increased. Alternatively, you could go long on a buy stop above a recent high.
In early 2013, the AOT formed a longer-term divergence, line a, and by the end of January, had turned negative. This was the start of a 24-day correction, though surprisingly, there was only one daily close below the 20-day EMA. The volume in February was low, line b, and the OBV moved above and below its WMA.
Then on February 21 ( line 3), the volume increased to 37 million from an average of 15 million the prior ten days. This moved the OBV out of its range, and the AOT rose to its best level in a month. HPQ closed up over 12% the following day.
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One of the hottest stocks for a good part of 2013 was Tesla Motors (TSLA). Any news related to its cars quickly moved to the front page in the financial press. From a technical perspective, the volume surge the week of April 5 (line 1) was very bullish. The OBV moved above the February high, line a, as TSLA formed a doji, closing at $41.37. The AOT was clearly positive but still below its prior peak.
The stock continued higher the following week, closing at $43.75 with both the OBV and AOT improving sharply, confirming the bullish outlook. From the weekly chart, there was little in the way of a pullback over the next seven months as TSLA made a high of $194.50 in early October.
The OBV did confirm the highs, line b, but dropped below its WMA two weeks later. The AOT peaked in May and then formed divergences (line d) both in August and late September, just before the price highs. The week after the AOT turned negative it bounced back to slightly positive as the OBV moved barely above its flat WMA, line 2. A sell signal was confirmed two weeks later as the OBV support at line c, was broken. Despite the recent rally, the AOT has stayed negative.
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In late 2013, the daily chart of Cablevision Systems (CVC) was a good example of a daily buy setup. The stock had been in a well-established downtrend from the August high of $20.16. The OBV was in a clear downtrend, line a, and was forming lower lows (line b). CVC formed three consecutive dojis in late November before the strong surge on November 21.
The volume was the heaviest since February as the OBV moved above its WMA and the AOT had its highest reading since August. Three days later, the OBV broke through its downtrend (line a) but many probably thought they had missed their opportunity to buy.
CVC had closed above its daily starc+ band and continued to test it for the next two days (point 2). This was a sign to wait as CVC was in a high-risk buy zone. Just four days later, CVC had corrected back to its 20-day EMA. The AOT bottomed eight days later, line 2, but did not drop below zero.
The WMA of the OBV was clearly rising and the 20-day EMA was tested for three more days before CVC again turned sharply higher. It gained over 12% in the next two weeks. CVC has dropped five days from the highs with the AOT now negative.
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Cray (CRAY) has been a stellar performer for the past two years as it was up 142% in 2012 and 72% in 2013. It is already up over 16% in 2014 as the weekly chart shows the strong close last week.
The volume has been leading prices since 2012 as the AOT moved firmly back above zero in August of 2012, and the OBV broke through its resistance (line a) the following month. During the post election selloff in November, the AOT dropped below zero for one week before flipping back to positive (line 1).
In early April of 2013, CRAY hit a high of $23.59 but then reversed to close the week lower and below the prior week's low. On a weekly chart, this is a sign of weakness that is almost always followed by a further decline. The OBV did form a slight negative divergence at the highs (blue line) but the AOT did not drop below zero until May.
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This plunge in May was in reaction to disappointing earnings as CRAY dropped to between the 38.2% and 50% Fibonacci retracement support levels calculated from the early 2012 lows. This area is typically a good buying zone in a correction. The AOT dropped below the zero line for two weeks before reversely sharply (line 2) as an HCD buy signal was generated.
Less than three months later, CRAY was making another new high at $28.58. There was no clear divergence at the highs though the AOT did peak a week early. The AOT drifted lower for the next 12 weeks, finally dropping below the zero line for two weeks last November. The volume was strong the following week (line 3), and the OBV moved back above its WMA. Buyers had another chance in December as CRAY dropped below its 20-week EMA while the OBV just tested its WMA (point c).
Of course, the AOT works in any market as long as they have adequate volume. The monthly analysis of the Spyder Trust (SPY) and PowerShares QQQ Trust (QQQ) turned back to positive last July while it was positive all year for the SPDR Dow Industrials (DIA).
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The PowerShares QQQ Trust (QQQ) had a sharp selloff in the fall of 2012 as it peaked in mid-September along with Apple (AAPL). The QQQ triggered an LCD the week after the highs and the OBV formed a short-term negative divergence, line a.
The AOT peaked in August and then formed lower highs, line b, and by early October dropped below the zero line. On the volume chart, the selling was quite heavy over the next four weeks as the OBV dropped well below its WMA. By late 2012, the OBV and the AOT had gradually improved as indicated by line c.
In early February of 2013, the AOT moved above the zero line for two weeks before turning negative. The positive signal the following week (line 2) was supported by higher volume than the prior two weeks. The rally over the next nine weeks was gradual, though it picked up steam in early May.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.