Several days ago we put out a request for ideas and topics you'd like to see discussed. Thanks for all the ideas, and keep them coming - we'll get to all of them eventually. For today, we'll just dive in and start taking a look at how we use and interpret a key volume-based indicator.

Boyd asks "Could you give some examples on the On Balance Volume indicator?"

As most regular readers will know, we often look at volume as a confirming tool, or as an early warning to major shifts in trends. One of easiest ways to quantify volume (but not the only one) is with an On-Balance-Volume (or OBV) line. We'll look at the other tools too, but let's first look at what an On-Balance-Volume line actually is.

Joseph Granville came up with the idea. Without getting into more detail than you need, just think of the OBV line as the net difference between bullish and bearish volume. If a stock or index is 'up' on any given day, that days volume as added to the previous days OBV figure. If the stock or index is 'down', than that days volume is subtracted from the previous OBV amount (yes, the OBV data is comprised of HUGE numbers). Needless to say, a rising On-Balance-Volume line is bullish, while a falling OBV line is bearish. But wait a minute - can't you basically see the same thing with just an ordinary chart, without the volume data? Yes, and no. Sometime the volume data is in agreement with a chart, and other times, it pays to know why it's not.

With volume, you get an additional clue about how likely a move is to continue...or not continue. It's the On-Balance-Volume line that shows you how the majority of the market players (i.e. institutions) are making their bets, so to speak. And while we're contrarians at heart, we still don't want to trade against the crowd - at least not until a trend has peaked or bottomed. By studying the direction of the OBV line, you can see how what the majority of Wall Street thinks about a stock or market, even if the charts direction says otherwise. 

As always, the best way to grasp a concept is to make it 'real' by applying a real-life example. We arbitrarily chose AT&T (T), which has had periods of bullish as well as bearish volume in the last few months. On the top portion of our chart, we've just plotted a regular chart of the stock. On the bottom portion of our chart, we've plotted the On-Balance-Volume line in blue, and we've also plotted a 100 day moving average of the OBV line in red (which we can ignore for now). The usefulness of the OBV line will become clear here. In August of 2003. AT&T's stock as well as the OBV line (both marked in blue boxes) started heading lower. In fact, you could say that one confirmed the other. In December of 2003, AT&T shares looked they might recover, but look at the OBV line - it was still generally pointed lower. Several people started buying in December, but the majority of the market was still selling. That eventually came back to bite those few buyers, as the selloff drove these shares down from 22 to 14. Seeing this bearish OBV line may have kept these folks from making that mistake.

AT&T (T) with on-balance-volume line - Daily

Chart provided by genesisft.com

We didn't get a real trend change until in the latter part of 2004, but remember what we said about the OBV line giving an early warning? Look at what happened in October of 2004. AT&T went ballistic. But look at what the OBV line did well before the bulk of that move, The On-Balance-Volume line crossed above its 100 day moving average several weeks before the big rally. That was the signal that institutions were buying a lot of AT&T shares, even though the stock wasn't moving much at the time. In both the bearish and the bullish case, volume made an accurate prediction. Now, with the On-Balance-Volume line falling towards the 100 day line again, we may see a repeat of 2003. However, we have to have the discipline to actually wait for the signal, as opposed to trying to outguess the market.

The point is, volume is far more important that you might think. This is especially true the longer you intend to hold a trade. On the other hand, volume can still provide important clues even to day-traders watching 15-minute charts - you just need to be aware of the direction that most of the market is going. Hopefully this OBV line with a 100 day moving average will give you a practical way of making volume-based decisions, but I encourage you to develop your own ideas around this theme too.

On a side note, the OBV data isn't accessible in all charting platforms. As alternatives, you may want to try to Chaikin lines or accumulation-distribution lines.

Price Headley is the founder and chief analyst of BigTrends.com, which provides daily stock and options recommendations and education.