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On-Balance Volume, The Overlooked Reversal Signal

Technicians focus for the most part of price patterns and changes, but may easily overlook the value of volume as an important signal for coming trend reversal.

Some charting techniques place great importance on volume spikes, but often do not go beyond this highly visible signal. Candlestick analysis combined with volume spikes is both popular and effective in identifying and confirming reversal, but it may be possible to anticipate changes in momentum and trend strength well ahead of a spike session.

Using on-balance volume (OBV) is one way to observe an emerging trend and a change in price momentum. Developed by well-known market predictor Joe Granville, OBV is a cumulative summary that reveals whether volume is led by buying or selling activity. In a bull market, accumulation by buyers leads volume, and in a bear market, sellers are in command. OBV distinguishes between these two.

Up-day volume is added and down-day volume is subtracted to determine the direction of the OBV trend. Chartists seek a divergence between OBV and price to anticipate changes in price momentum, and this makes OBV not only an early predictive indicator, but also a confirming indicator of what chartists might see in other signals.

When the day's closing price is higher than the previous day, then the currently calculated OBV is added to the prior total; when it is lower, the day's OBV is subtracted. Any divergence in the direction of price and the cumulative direction of OBV is viewed as an early reversal signal. Chartists who see this divergence will want to confirm it with other signals that momentum is shifting.

Today's free charting and automatic calculation of even the most complex indicators makes charting much easier than in the past. OBV can be added to daily charts with the click of a button. However, for those who want to know how OBV is calculated, here is the formula:

upward-moving session

P + V = O

downward-moving session

P - V = O

In this formula, 'P' is the previous day's cumulative OBV, 'V' is the current day's volume, and 'O' is the new OBV.
A flaw in the calculation of OBV is that it assigns absolutely positive or negative value to an entire day even if price tilts only slightly in one direction. So a day that is up only 1/4 point, the entire day's volume is added. It is given the same value as a day whose price jumps six points for the same stock. This limitation is not always going to distort the outcome, however. Because OBV is cumulative, a chartist may easily assume that marginally up-moving days are offset by marginally down-moving days.

OBV is a good early indicator that momentum in the current trend is weakening, serving as a red flag. Chartists may seek confirmation through other means, including trading range tests, triangles in the price trend, or reversal candlestick patterns.

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