On-Balance Volume Reveals Market Player Strategy

While looking at daily volume can help investors determine where price action might be headed, on-balance volume (OBV) produces clearer signals that can assist investors looking for the best times to trade.

Volume shows crowd sentiment as price bars carve out patterns that predict a bullish or bearish outcome. OBV involves an ongoing tally of the flow of volume. OBV’s indicator line can reveal buying and selling moves of the smart money—institutional investors and other major players.

What Is On-Balance Volume

On-balance volume (OBV), developed by Joseph Granville in the 1960s, packs enormous use into a simple accumulation-distribution tool that totals up and down volume cumulatively, adding or subtracting the result in a continuous sub-total.

The OBV formula generates a smooth indicator line that carves out highs, lows, and trendlines similar to price bars. Comparing relative action between price bars and OBV generates more actionable signals than the green or red volume histograms commonly found at the bottom of price charts.

While the formula generates a daily value, that value is less important than the indicator line that it creates, viewed over time.

Volume supporting price action creates convergence, adding reliability to directional signals. Opposing action creates divergence, warning that market forces are in conflict, with one side eventually taking control. 

Volume interpreted through an accumulation-distribution indicator clarifies this process, giving reliable signals that influence position choice and trade management. 

How OBV Can Reveal Market Player Strategy

Traders and analysts watch OBV to try to determine what the large players in the market are doing. Since volume changes supposedly precede price changes, keep an eye out for a big change in OBV without a similar change in price (a divergence).

That can indicate that institutional investors and other market players are taking positions in the market before a multitude of smaller investors does. When these other investors notice and jump on the trend, pushing up OBV and price, the smart money will sell out of their positions, taking nice profits with them.

What OBV Can Predict

OBV gives the most reliable feedback around tests of major highs and lows, making it a perfect tool to measure the potential for breakouts and breakdowns. 

It’s a simple process, comparing the indicator’s progress to price action and noting when a security’s price and the indicator move together (convergence) or when they move in opposite directions (divergence). This gives way to some key predictions:

• OBV hits a new high while the price tests resistance: bullish divergence, predicting the price will break resistance and surge higher, playing catch-up.
• The price hits a new high while OBV grinds at or below the last resistance level: bearish divergence, predicting the rally will stall or reverse.
• OBV hits new low while price tests support: bearish divergence, predicting the price will break support and surge lower, playing catch up.
• The price hits a new low while OBV grinds at or above the last support level: bullish divergence, predicting the sell-off will stall or reverse.
• OBV matches the price action, higher or lower: bullish or bearish convergence, depending on direction.

Limit OBV analysis to major testing zones on the daily chart. It’s natural for conflicting relationships between price and volume to develop during the course of a sideways market, reducing the indicator’s reliability between contested levels.

It also doesn’t scale well, with intraday and weekly OBV failing to produce consistently reliable signals.

Examples of OBV

Let’s look at two common OBV scenarios:

CME Group (CME) rallies to 80 in June (1), posting an OBV high swing. It pulls back and exceeds that high in November but OBV fails to reach its prior high (2), signaling a bearish divergence.

The rally fails, giving way to a sell-off that reaches an 11-month low in April.

The stock then enters an accumulation phase, with OBV and price ticking higher in unison for seven months.

OBV lifts to a multiyear high in September (3) while the price is still trading under the prior year’s high, triggering a bullish divergence that predicts the strong December breakout.

Celgene Corporation tops out early in the year just below 90 (1) and enters a correction that shows an extensive distribution. It starts to recover in April, gaining ground in a steady uptick that lifts price into the previous high in June while OBV fails to reach that level. 

The stock grinds sideways for two months in a symmetrical triangle and breaks out (2), lifting toward 100 but OBV continues to lag, grinding well below the high posted earlier in the year.

This divergence forces the uptrend to stall and undercut the breakout level, shaking out hopeful buyers while OBV makes a slow and steady recovery, finally joining price at a new high in November (3).

Stocks can easily breakout or breakdown when OBV lags price behavior, but the divergent action waves a red flag that predicts whipsaws until the price turns to meet OBV or OBV turns to meet the price.

This testing behavior tracks the second phase of the action or reaction resolution cycle. That’s why traders should look for OBV to match the lead price before they take a risk on new breakout or breakdown positions.

The Bottom Line

On-balance volume can show the intent of market players, often before price action generates a buy or sell signal.

Because of this, investors can use OBV to provide insights that can help them make trading decisions. Specifically, it’s most useful as an entry filter whenever a security is testing a major support or resistance level.