Having a stable of trading tools that helps you timing when to buy stocks will drastically improve your trading profits. However, many traders, particularly novice traders, suffer from paralysis by analysis. There are simply too much data, too many strategies, and too many indicators for any trader to completely master.
Implementing volume centric momentum indicators provides you several key benefits, none the least of which is simplicity of reading. Momentum indicators tend to be very simple to interpret, and can provide traders important insight into market trends,
On Balance Volume (OBV)
On balance volume is a momentum indicator that was created by Joe Granville in 1963. The on balance volume indicator is designed to measure positive volume flow. The key concept to understand is that volume preceeds price, and as such, measuring the flow of volume (into or out of a stock) provides traders a leading indicator on market trends.
On Balance Volume is constructed as a running total of volume flow. Volume is added to the total when price closes to the upside, and subtracted from the total when price closes to the downside. This is a key concept that the indicator is based on closing Equallogic Prices, I’ll discuss why in a moment.
Traders use the OBV indicator to find divergences between volume and price.
The definition of divergence as supplied by StockCharts.com
A situation that occurs when two lines on a chart move in opposite directions vertically. People often look for divergences by comparing a stock’s direction to the direction of its RSI, its MACD or its Stochastic Oscillator. There are two kinds of divergences: positive and negative. A positive divergence occurs when the indicator moves higher while the stock is declining. A negative divergence occurs when the indicator moves lower while the stock is rising.
A divergence between On Balance Volume indicates that 1) insitutional traders are taking profits, 2) volume is not supporting the current trend, and 3) that momentum is fading.
A divergence in OBV opposing the direction a trader is looking to enter a stock is a warning signal against entry. OBV sloping positively in the direction of your trade would provide confirmation of your entry.
Strengths and Weaknesses of On Balance Volume
On Balance Volume’s primary strengths are the simplicity of reading the indicator, and the ability to identify weakening trends. However, OBV does have a few weaknesses that traders need to be aware of:
The primary weakness of the OBV indicator is that it rquires a full day’s price action to construct. Thus, it is not well suited to intra day trading.
The subsequent weakness of OBV revolves around gaps in price. Since no trading volume occurs in a price gap, OBV discounts this piece of price movement.
To compensate for this weakness, a very prominent trader named Tom Bierovic created a derivative of On Balance Volume which he named On Balance True Range.
On Balance True Range (OBTR)
Before I discuss the implementation of OBTR, it is important to understand that there is a significant statistical relationship between volume and the price movement of a stock. Statistical analysis of this relationship has been well documented, such as in this MIT Laboratory for Information and Decision Systems report: Relationship between Trading Volume and Security Equallogic Prices and Returns.
True Range
The first component of the OBTR momentum indicator is called True Range. True Range. True Range, as defined by J. Welles Wilder is:
True Range (TR) which is defined as the greatest of the following:
The current High less the current Low. The absolute value of the current High less the previous Close. The absolute value of the current Low less the previous Close. If the current high-low range is large, chances are it will be used as the True Range. If the current high-low range is small, it is likely that one of the other two methods would be used to calculate the True Range. The last two possibilities usually arise when the previous close is greater than the current high (signaling a potential gap down or limit move) o
