I have been writing about the importance of transaction volume for confirmation of stock or index chart pattern moves. Price rise should be accompanied by higher volumes. Price falls should be on lower volumes.
Rising price on static or lower volumes produces a 'negative divergence' - which indicates the rise may end soon. But what if the stock price or index is moving sideways and the volume is going up, or down? Does that have any technical significance for market movements?
Enter the concept of 'On-Balance Volume', a momentum indicator developed by Joseph Granville in 1963. It is calculated on the basis of a rather simplistic assumption about the closing price of a stock, or the closing level of an index:
If the closing price or index level of a particular day is higher than the immediately preceding trading day's, then the entire volume of transactions is added to a cumulative volume total (named On-Balance Volume, or OBV).
If the closing price or index level is lower than the immediately preceding trading day's, then the entire volume of transactions is subtracted from the OBV.
If the closing price or index level of a particular day remains unchanged from that of the immediately preceding trading day's, the OBV also remains unchanged.
What is the significance of this momentum indicator? A rising OBV means accumulation (i.e. the entry of smart-money); a falling OBV means distribution (i.e. stronger hands transferring their holdings to weaker ones).
Why is the calculation of OBV simplistic? A stock or index usually has several up and down movements throughout the trading day. On a higher closing day, the volume of all buy and sell transactions are added to the OBV. Logically, the total volume of all sell transactions should be subtracted from the total volume of all buy transactions before adding to the OBV.
Likewise, for a lower closing day, the difference between the total sell volume and the total buy volume should be subtracted from OBV. When the indicator was developed by Joe Granville, computers were not as readily available or accessible. So to keep matters simple, logic was given short-shrift.
Let us look at an example. What better choice than the BSE Sensex index chart pattern?
During Sept '08 and Oct '08, the OBV followed the Sensex downwards. In Nov '08 and Dec '08 also, the OBV danced together with the Sensex in lock-step.
Now comes the interesting part. See what happened during Jan '09 and Feb '09. While the Sensex fell, the OBV remained flat. A positive divergence, indicating a possible trend change.
Also interesting to observe is what happened when the rally took off during Mar and Apr '09. The OBV made a higher top in Apr '09 when the BSE Sensex index was at around 11000, than when the index was at 16000 in Aug '08. This was a true sign of accumulation.
Unfortunately, this particular charting software doesn't have volume information updated from May '09 onwards.
I would like to thank reader Rajeev for asking a question about accumulation and distribution in the 'comments' thread of this post. It motivated me to write this article.