AAII Journal/May 2001 29

TECHNICAL ANALYSIS

By Wayne A. Thorp

The main function ofthe OBV is to trackthe activity of smartmoneylarge tradersand investors whomay possess insideknowledge regardingthe fundamentals ofa company or themarketso you canbenefit from theirinformation withoutactually knowing it.

MONITORING THE SMART MONEYBY USING ON-BALANCE VOLUME

Wayne A. Thorp is assistant financial analyst of AAII.

The study of technical analysis focuses primarily on price and volume.Perhaps it is not surprising that price garners most of the attention. However,volume deserves more than a cursory glance.

Volume is important because it provides information about the strength (orlack thereof) of price movements.

Heavier volume should be in the direction of the existing trendvolumeshould be relatively higher on up days during an uptrend and on downdays during a downtrend. Furthermore, price movements on heavier-than-normal volume are more apt to continue than those with light(er) volume.

One of the more useful technical indicators used by technicians is on-balance volume (OBV), which was introduced by Joseph Granville in his1963 book Granvilles New Key to Stock Market Profits. OBV takesvolume analysis beyond the volume bars typically seen below a price chart andprovides a visual representation of the volume flow for a given security,enabling you to compare it against the price action.

CALCULATING OBV

One reason for OBVs popularity is its broad applicationstocks, futures,options, indexes, and markets. It is also relatively easy to calculateas longas you have price and volume data for the period you wish to analyze, youcan create the OBV. The value of the OBV is strictly arbitrary: The day youbegin calculating the OBV determines the initial value. What is of greaterimportance, however, is the trend and direction of OBV.

To calculate the OBV, you begin by comparing the closing price of one dayto the closing price of the prior day: If the price is higher than it was the prior day, then all of that days

volume is added to the previous days volume; If the price is lower than previously, the days volume is subtracted from

the previous days volume; If the price has not changed from the prior day, the days volume is

ignored.Table 1 shows you how to calculate the OBV using daily data for General

Electric for the period February 28March 16, 2001. However, most techni-cal analysis programs include OBV in their selection of technical indicators.

SMART MONEY VS. THE PUBLIC

When Granville introduced OBV, he argued that the market is divided intotwo groupssmart money (made up of large investors and traders), and thegeneral public. The smart moneyarmed with better informationis able tobuy securities at a lower price than the public. Granville theorized that,during bull markets, the smart money bids up prices and participates inbuying for the majority of the upward price move. Once the smart money isfully invested, these investors wait for the final segment of the move. This isfueled by the general public who, after taking note of the upward move in

30 AAII Journal/May 2001

TECHNICAL ANALYSIS

OBV is a running cumulative total of positive and negative volume numbers. It can be stated mathematically as:

If C1 > C0:

OBV0 + V1 = OBV1

If C1 < C0:

OBV0 V1 = OBV1

If C1 = C0:

OBV0 = OBV1

Where:

C1 = Todays Closing Price

C0 = Previous Days Closing Price

OBV0 = Previous Days OBV Value

V1 = Todays Volume

OBV1 = Todays OBV Value

When you begin your OBV calculation, the first days volume equals plus or minus the OBV (depending on if the days priceis higher or lower than the previous day), since there is no prior OBV value to add the first days volume to or to subtract itfrom.

As an example, well use GE, shown here, comparing the closing prices (horizontal lines to the right of the price range bars)of February 28 ($46.50, not shown) and March 1 ($45.91). The volume was 23.96 million on March 1.

Since the close for March 1 was lower than the close of February 28, the OBV value for March 1 is negative 23.96 million:

3/1: $45.91 < $46.50:

0 23.96 mil = 23.96 mil

For March 2, the close of $44.57 is below the close of March 1. This time we subtract the volume of March 2 from the OBVvalue for March 1, giving us an OBV of negative 45.95 million:

3/2: $44.57 < $45.91

23.96 mil 21.99 mil = 45.95 mil

On March 5 (the next business day), the closing price is above that of March 2. 21.99 million shares were traded onMarch 2. In this case, we then add the volume from that day (16.68 million shares) to the prior days OBV, giving us an OBVvalue of negative 29.27 million:

3/5: $45.08 > $44.57

45.95 mil + 16.68 mil = 29.27 mil

Looking at the chart for GE for this same period, you can see the interaction between price activity, volume, and the OBVline. The OBV line begins in negative territory, reflecting the fact that GEs price fell on the first day of the period. Beingsure to compare only the closing prices, you can see where the OBV line increases on those days the closing price is abovethe previous close and falls on those days where the close is below the previous days closing price.

Lastly, focus on March 12on this day, GEs price fell $4.21 from the close of the 9th. Also on this day, GE experienced thehighest trading volume during the period45.71 million shares traded. On this day, volume behaved as we would expectitvolume increased when there was a relatively large price move. As a result, OBV dropped sharply on the 12th as well.

TABLE 1. CALCULATING OBV: AN EXAMPLE

GE PRICE, VOLUME, & OBV

$

AAII Journal/May 2001 31

TECHNICAL ANALYSIS

FIGURE 1. BIOGEN OBV BREAKOUT

price, jump on the bandwagon andcontinue to bid up the price. How-ever, the general public is buyingshares from the smart money, who isnow selling their shares and reapingthe gains. When the general publicrealizes what is taking placemainlythat the price is in free-falltheyrush to sell, further depressing theprice. Therefore, in order to success-fully use OBV, the division of themarket between smart money and thegeneral public must exist. The smartmoney must have someone fromwhich to buy and which to sell,which is where the general publicenters the picture.

MEASURING FUNDAMENTALS

In the book The TechnicalAnalysis of Stocks, Options, &Futures, William Eng draws acomparison between the OBVindicator and fundamental analysis.The main function of the OBV is totrack the activity of smart moneylarge traders and investorswho maypossess inside knowledge regarding

the fundamentals of a company orthe market as a whole. By followingthe OBV, you may be able to gaugewhere the smart money is tradingand, consequently, benefit from theinside knowledge possessed by thesmart money without knowing whatthis information actually is.

TRENDS IN OBV

Over time, the OBV line will takeon a trendeither up, down, orsideways. When the OBV line is inan upward trendmeaning thateach new peak in the OBV line ishigher than the previous peak oreach new trough is higher than theprevious troughthis is an indica-tion that the security is undergoingaccumulation or buying. During anupward trend there is more volumeon days in which the price goes upversus those days where the pricefalls. This is viewed as a bullishcondition.

In contrast, when the OBV line isfalling or in a downtrend, eachsuccessive peak in the OBV line is

lower than the previous peak oreach trough is lower than theprevious trough. This is a period ofdistribution or selling, which meansthat volume is heavier on dayswhere the price falls in relation todays where the price increases. Sucha trend is bearish in nature.

There will also be times when theOBV line is neither making newhighs or new lows. This sidewaystrend indicates a doubtful trend.During this phase, traders arelooking for breakouts in OBV,which would indicate the beginningof either an upward or downwardtrend.

Once a trend is in place, it canonly be broken by a reversal intrendgoing from upward todownward, or vice versaorentering a doubtful trend fromeither an up or down trend.

In examining the trends in OBV,you are looking for breakoutswhen the OBV changes to either arising or falling trend. Thesebreakouts typically occur ahead ofprice breakouts, so traders should

buy long on OBV upsidebreakouts or sell shortwhen the OBV makes adownside breakout. Onceyou have entered aposition based on OBV,you should remain in ituntil the trend changes.

Figure 1 illustrates anOBV breakout for Biogen(BGEN). As you can seefrom the price chart,Biogen entered a periodof decline beginning inmid August of 2000,during which time moneyflowed out of the stockas OBV fell. In earlyOctober, Biogen found abottom and pulled backinto a trading rangebetween $52 and $63.Over the next threemonths, both the priceand OBV fluctuatedwithin a defined range.Then in mid-January2001, the OBV value

32 AAII Journal/May 2001

TECHNICAL ANALYSIS

FIGURE 2. ALTERA CORP. OBV NEGATIVE DIVERGENCE

FIGURE 3. SAFEWAY INC. OBV NEGATIVE DIVERGENCE

rose above its previous high value, asignal that a breakout is takingplace, followed a couple of dayslater by the price moving outside ofthe trading range. In this example,an investor wouldwant to go longwhen OBV beganreaching new highsand stay in the tradeuntil the upwardtrend in OBVreversed itself. WithBiogen, the breakoutto the upside lastedroughly a month, atwhich point bothOBV and pricereversed course.

INTERPRETINGOBV

When viewing theOBV line in tandemwith a price chart,the OBV line isconfirming the pricemovement when itmoves in the samedirection as price.However, when

price moves in one direction and theOBV moves in the opposite direc-tion, a negative divergence is takingplace. This serves as a warning that

the current pricetrend may bereversing. Whensuch a circumstanceexists, you wouldwant to place atrade in the direc-tion of the OBVline because,eventually, weexpect the pricetrend to reverse inthe direction of theOBV line. In otherwords, if the OBVline were fallingwhile the price is inan uptrend, youwould want to sellor go short. Incontrast, if theOBV line wererising while pricesare falling, youwould want to buyor go long. Keep in

mind that it is the direction of theOBV line that is important, not theOBV values themselves.

Figure 2 is an example of negative

AAII Journal/May 2001 33

TECHNICAL ANALYSIS

FIGURE 4. TARGET CORP. PRICE FOLLOWS OBV TRENDdivergence between the OBV lineand price. Looking at the pricemovement of Altera Corp. (ALTR)in June and July 2000, we see that itmakes several new near-term lowswhile OBV is reaching lows that arebasically at the same level. Wewould expect the OBV line to reachnew lows with the price in situationssuch as this. Eventually after reach-ing a new near-term low at the endof July, Altera rose in price from$44 to $65 in less than a month.This is an example of price reversingitself in the direction of the OBV.

Another example is shown inFigure 3 for Safeway Inc. (SWY).You can see in the chart that,between July and October of 2000,Safeways price reached three newnear-term highs. However, each timethis high was reached, the OBVcreated a peak that was lower thanthe previous one. Here we wouldexpect the price to move in tandemwith the OBV linewhich takesplace when Safeway makes anabrupt fall from roughly $54 tobelow $46 in three days. The samething happens again less than twomonths later. The chart shows thatin late November 2000 and lateJanuary 2001, the price reachedhigher highs, while the OBV linereached to successive lower highs.Once the second high was reached,the price took another precipitousdrop from almost $63 to just above$51 in a matter of days.

Lastly, Figure 4 illustrates asituation in which the stock price

enters an uptrend to match themovement in OBV. In this example,Target Corp. (TGT) was in themidst of a downtrend in Septemberand October of 2000. While theOBV line was falling through thefirst half of this downtrend, itreversed course in late September. Atthis point, an investor should be onalert for the price to move upwardwith OBV. A week or so later,Target Corp. reached a new low andthen entered an uptrend.

CONCLUSION

Students of technical analysisshould be aware of the importancevolume plays in the analysis process.It serves to confirm the validity of a

trend and, as we have shown usingthe on-balance volume indicator, canprovide a warning sign of potentialchanges in the current price trend.

Like any other technical indicator,OBV should not be viewed inisolation. By using it in tandem withother indicators, you are betterequipped to identify potential pricemovementsand trade accordingly.

RESOURCES Achelis, Steven, Technical Analysis

from A to Z, McGraw-Hill. Murphy, John, The Visual Inves-

tor: How to Spot Market Trends,John Wiley & Sons.

Eng, William, The TechnicalAnalysis of Stocks, Options, &Futures, Probus Publishing. F

View the on-balance volume indicator of any stock in the Quotes & ResearchQuotes & ResearchQuotes & ResearchQuotes & ResearchQuotes & Research area using the JavaChart.

Link to the best charting Web sites from AAIIs Top Web Picks in the Investor ResourcesInvestor ResourcesInvestor ResourcesInvestor ResourcesInvestor Resources area.

Post your opinion on the on-balance volume indicator on our Stocks Message BoardStocks Message BoardStocks Message BoardStocks Message BoardStocks Message Board.

Read the following related article, linked through the on-line version of this article:

A Look at Different Measures of Short-Term Influences on Prices