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ON BALANCE
VOLUME
In our last several "Inside the
Black Box" articles I have argued that swing traders often pay too
much attention to price and not enough to volume. Certainly, it is price
that rewards us for an astute trade and penalizes us for a less accurate
one. Volume does not put money into or take funds out of our brokerage
account.
Yet as I have tried to demonstrate, swing traders overlook volume at
their peril. Volume should be an indispensable part of the analysis of
every price pattern. Astute swing traders should pay particularly strong
attention to volume on breakouts, climactic bottoms, and spikes after
sustained uptrends. Volume divergence, when price is rising but volume
is trending down, is a strong warning that price itself will likely soon
fall.
Joseph Granville, creator of the On Balance Volume indicator, shares
this same insistence on the importance of volume analysis. He exclaims
that volume precedes price, and he even goes so far as to argue that volume
is cause and price is effect.
The indicator he designed to track the flow of volume in and out of a
stock or index is called "On Balance Volume," or OBV. OBV is a
running total of volume. Designed in the early 1960s, before computers
were used in stock analysis, its calculation is simple. An arbitrary
number (usually a very large one) is used to begin an OBV line. On days
when price closes higher, all the volume of that day is added to this
line. On days when price closes lower, the volume is subtracted from the
line.
For example, let's say that XYZ went from $20 to $21 in a day and traded
100,000 shares. The next day it retreated exactly to $20, but traded
only 50,000 shares. Even though price stayed the same for the period,
the OBV line would have increased by 50,000 -- the difference in trading
volume between day #1 and day #2. If this same pattern were to repeat
itself for several days in a row, then the security's price would remain
constant, yet it would have a rising OBV line. Granville would argue
that this situation is highly bullish. The On Balance Volume Line is
rising even though price is staying the same. Eventually, he would
argue, this hidden demand will surface and will force prices higher.
An OBV line typically takes the form of a zig-zag. It can trend up (a
bullish sign), down (a bearish sign) or sideways (in which case the OBV
trend is doubtful).
When analyzed in conjunction with the price chart, the OBV line can do
one of three things. First, it can confirm the price movement, trending
upward as prices rise. Second, it can diverge bullishly or bearishly
from price. A bearish divergence would occur when prices hit a new high,
but the OBV line makes a lower high. A bullish divergence occurs when
prices hit a new low, but the OBV line makes a higher low. Finally, the
OBV line can act as a leading indicator. If OBV breaks out to a
new high, but price is below the previous high, then the probability is
that prices will follow it to higher ground. Swing traders can analyze
OBV by examining trendlines and moving averages.
The three-month chart of grocery chain Albertson's (ABS) shown below
illustrates the importance of OBV analysis. In the period marked
"1," ABS began an uptrend that took the shares from $19 to
$23. The OBV line mimicked the price trend and rose steadily to a peak
along with price in early September.
In early September ABS moved about $1.50 -- a huge
amount for this stock -- on a volume spike. (For more on volume spikes,
please visit our issue archives.) For two more days prices rose. Look
carefully, however, at the OBV pattern that is circled and is marked
"2." Note that there was bearish divergence as price hit a new
high, but the OBV line was slightly lower. Note also that a trendline
drawn on OBV broke before the trendline on price.
As Albertson's shares declined into mid-September, the OBV indicator
also trended lower. In the period marked "3," note, however,
that there was bullish divergence. Prices trended lower, but the OBV
indicator went higher, implying that the stock would reverse in price.
As the chart ends in the period marked "4", ABS is well below
its early September high. The OBV line is testing is previous high. A
breakout into new high ground by OBV implies that prices should trend
higher. For this reason, as well as several others, I flagged
Albertson's as a "Stock to Watch" in today's
newsletter.
Many technical analysis tools (such as moving averages) are referred to
as "lagging indicators" because they describe changes in
pattern after the fact. OBV is one of the few tools that can serve as a
leading indicator. When it diverges from the underlying price action,
its message should be taken very seriously.
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