On-Balance Volume: Overview, Pros, Cons and Trading Strategies

In this article, we will discuss:

• What Is On Balance Volume?
• On-Balance Volume: Explained 
• How Does On Balance Volume Indicator Work?
• Benefits and Limitations of Using On-Balance Volume in Stock Market
• On Balance Volume Trading Rules
• Formula to Calculate On Balance Volume
• Conclusion
• Frequently Asked Questions

What Is On Balance Volume?

If you are a seasoned trader or a novice, knowing on-balance volume is important while dealing in the stock market. It is one of the most useful technical indicators as it measures selling and buying pressures and helps to predict stock price movements.

In this article, we will discuss everything about on-balance volume to make informed decisions while trading.

On-Balance Volume: Explained 

To answer your question about what is on-balance volume, it is a momentum indicator, combining trading volume and price movement to get an insight into buying and selling pressures in the stock market. It serves as a useful instrument for traders as it aids in the recognition of possible shifts in trends and validates ongoing trends. 

The OBV indicator functions based on a straightforward concept: when the closing price of an asset surpasses the previous close, the trading volume is incorporated into the OBV. Conversely, if the price concludes below the prior close, the trading volume is deducted from the OBV.

How Does On Balance Volume Indicator Work?

The On-Balance Volume (OBV) is a trade pressure indicator that is calculated by adding volume on days when the price closes higher and removing volume on days when the price closes lower. If the closing price of a certain security is higher than the previous day's, the volume is deemed up-volume; if the closing price is lower, the entire day's volume is classified as down-volume.

Moreover, increased trading volumes are typically associated with potential uptrends in stock prices, while declining volumes suggest potential downtrends. The alignment of volumes with price movements results in reliable directional signals and convergence. Conversely, when volumes move in the opposite direction, creating divergence, it indicates conflicting market forces.

Benefits and Limitations of Using On-Balance Volume in Stock Market

Before using the on-balance volume indicator, you should know the major benefits as well as limitations of this tool. Below we have categorised the pros and cons of the OBV.

Benefits

• It allows retail investors to trace "smart money", which denotes the money being invested by different institutional investors, like pension funds, banks and more.
• On-balance volume is a straightforward tool, requiring only the summation of cumulative up and down volumes to generate distinct trading signals. 
• Comparing OBV with price bars enhances signal accuracy.
• Volume is a fairly accurate predictor of market movements. Thus, OBV helps figure out the movement of stock prices that are flat, with a decrease or increase in substantial volume.
• It proves valuable in assessing significant market peaks or troughs. It serves as a useful tool for investors to gauge potential price breakouts and breakdowns in an asset.

Limitations

• On-balance volume indicator does not give necessary information regarding the bigger picture of trading signals.
• This tool is not suitable for day traders since it usually does not perform well if the price of an asset stays within a specific range.
• When some large movement in the market takes place in a single day, it leads to a massive value change. Hence, a substantial increase in trading volume caused by a stock being added or deleted from an index might throw off this indicator for a short period.

On Balance Volume Trading Rules

In an upward market trend, an on-balance volume trading strategy aligns with the price movement as the charts consistently form higher peaks and higher troughs. This results in both the price chart and OBV chart appearing nearly identical. When both charts exhibit synchronised movements, it indicates a strong upward trend, signifying that volume supports the rising prices.

Conversely, in a downward trend, OBV should mirror the price by forming lower peaks and lower troughs. This alignment confirms that volume is backing the downtrend, maintaining its strength. 

However, there may be a point when Price and OBV no longer exhibit correlated responses. It might take place in any of the forms stated below:

• Non-confirmation of an upward trend
• Advanced breakout
• Non-confirmation of a downward trend
• Advance breakdown

Formula to Calculate On Balance Volume

The on-balance volume formula is simple and as follows:

• OBV = Previous OBV + Current Volume( if the closing price is higher than the previous closing price)
• OBV = Previous OBV – Current Volume (if the closing price is lower than the previous closing price)

Note: If the closing price is the same as the prior closing price, the previous OBV is used.

Conclusion

The on-balance volume indicator is a significantly useful tool for investors and traders to understand market trends. Using this helps you get an insight into buying and selling prices after combining the trading volume and price movement, specifically understanding the bearish and bullish trends. 

However, even if using this indicator helps understand market scenarios, its limitations, as discussed above, do not make it entirely reliable.

Also, make sure to use the New Gen SAMCO Trading App to use their on-balance volume indicator to make informed trading decisions in the stock market.

Frequently Asked Questions

• What is on-balance volume indicator's primary trading purpose?

The primary trading purpose of using an OBV indicator is to help traders judge if the rising price of a stock is because of a false movement or a huge upward trend.

• What is the difference between on balance volume and volume price trend?

The Volume-Price Trend or VPT indicator, similar to OBV, merges volume and price changes. Yet, VPT adds complexity by considering the percentage change in price. 

• Are accumulation/distribution (AD) curves and OBV similar?

OBV and Accumulation/Distribution (AD) curves are similar since they both indicate momentum using volume change and predict different price movements. 

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