What is On-Balance Volume

On-Balance Volume (OBV) is a technical analysis indicator that predicts the change in a stock’s price through its volume flow. When trading financial securities, price and volume are considered two key factors in analysing momentum and understanding market direction. For traders, several indicators are available to provide detailed insights into the market’s momentum and help identify trading opportunities or trend reversals. Read more to learn about how the On-Balance Volume indicator works and how to trade using the same.

What is On-Balance Volume?

The On-Balance Volume is a cumulative volume-based momentum indicator. The indicator was first introduced as a metric by Joseph Granville in his 1963 book called ‘Granville’s New Key to Stock Market Profits’.

The indicator considers the volume of a security's flow to predict its momentum and price changes. As a cumulative volume-based indicator, the indicator adds the volume to the previous OBV on up days and subtracts it from the OBV on down days.

The positive or negative volume flow of a financial security can help traders get insights into the buying or selling pressure in the market. Consequently, traders can use the indicator’s signals to predict short-term price changes of an asset.

Read More: How Does the Commodity Market Work?

How is OBV Calculated?

Before we learn how to trade using the OBV, let’s take a look at how to calculate the on-balance volume.

The OBV calculates the cumulative volume flow of a financial security by adding or subtracting the volume based on the asset's closing price.

If the closing price is higher than the previous day’s closing price:

OBV = Previous OBV + Today’s volume

If the closing price is lower than the previous day’s closing price:

OBV = Previous OBV – Today’s volume

No changes are made to the OBV if the closing price is equal to the previous day’s closing price.

OBV = Previous OBV

Using OBV in the Commodity Markets

Although OBV was originally created to predict the short-term price movements of stock prices, it has since been used for other financial instruments like commodities. The OBV is a momentum indicator that can help traders analyse the trend of the volume in addition to the change in volume.

Trend Confirmation

The trend of the OBV can help traders gauge the trend of the price of a commodity. Typically, before an uptrend begins, a rise in volume can be seen. This rise in volume can be seen as an uptrend in the OBV. Similarly, a downtrend in the OBV can indicate a decline in the price of the commodity.

Divergence Signals

With the help of the OBV, traders can spot divergence signals and identify potential reversals. For example, a rise in the price of a commodity along with a declining OBV can indicate a trend reversal or vice versa. Sharp changes in the OBV, while the price of the commodity remains flat, can also be seen as an indicator of significant price movements in the near term.

Breakout Confirmation

Traders also use the OBV as confirmation for a breakout or breakdown. When the price of a commodity breaks a key level of support or resistance, the OBV can be used as confirmation for the breakout. For example, if the OBV rises as the price of a commodity breaks a resistance level, it signals the strength of the breakout and provides additional confirmation to traders.

Trading Commodities Using OBV: Examples

Let’s look at examples of how the OBV can be used while trading commodities - 

Gold futures are trading at ₹85,500, with a key resistance level at ₹85,700. The current OBV is 1 million. After a couple of days, the OBV rises to 1.5 million. At the same time, gold futures breached the resistance level of ₹85,700.

Since the OBV is in an uptrend and has risen in tandem with the price of the commodity, traders can interpret this as a confirmation signal of the breakout.

The OBV can also be used to spot divergences and identify reversals -

For example, crude oil futures are trading at ₹6,500. The futures contracts continue to rise in price and are currently trading at ₹6,600. However, the OBV declines while the price of the futures contracts increases. This is a divergence signal, which can be interpreted as a potential trend reversal.

Limitations of OBV

When trading commodities using the OBV, it is essential to understand the limitations and conditions under which the indicator may not perform as expected.

• The OBV is a leading indicator; however, it may produce less reliable signals in markets with lower trading volumes, due to the chances of anomalies in the volume.
• The OBV may also generate false signals in commodities that are not traded often, as these commodities may see irregular price movements.