On Balance Volume Indicator Explained

Definition of the On Balance Volume Indicator

The On Balance Volume is a momentum indicator which makes use of the volume of trade in a currency pair to predict changes in the price action of that currency pair. The indicator was introduced by Joseph Granville and serves as a way of measuring of positive and negative volume flow. The principle behind the workings of the indicator is that if volume increases or decreases without a matching increase or decrease in the price of an asset would lead to a divergence situation where price of the asset would eventually have to correct itself to catch up with the volume changes.

Components of the On Balance Volume

The On Balance Volume indicator is made up of the OBV indicator line. The On Balance Volume (OBV) line is plotted by summing up positive and negative volume for the asset. If the asset closes higher than the previous period’s close, then the volume is positive. If the asset closes lower than the previous period’s close, then the volume is negative.

OBV

Closing price > prior closing price then:

Current OBV = Previous OBV + Current Volume

Closing price < prior closing price then:

Current OBV = Previous OBV –  Current Volume

There is no change in Current OBV if the asset closes at the same price level as it did in the previous period.

Usage of Indicator

Before we move on to how the indicator is used, it must be remembered that:

  1. The absolute value of the OBV indicator is in itself, not very important for forex trading decisions.
  2. What really counts is the characteristics of the OBV line itself such as the trend the line has assumed, potential support and resistance areas in the context of measuring and trading breakout scenarios.

Indicator Settings

The indicator is listed on the MT4 as a volume indicator. To attach it to the MT4 chart, click on Insert -> Indicators -> Volumes -> On Balance Volume

OBV1

The indicator line of the Money Flow Index indicator can be enhanced by either increasing the line thickness or by changing the colour of the indicator to make it more visible.

Usage of the On Balance Volume in Forex Trading

The On Balance Volume is an indicator which can be used as a standalone indicator through and through. We will demonstrate two ways to use the OBV indicator.

1) Divergence Trade

As a standalone indicator, the On Balance Volume stands out as a divergence trade indicator. Divergence trades with volume indicators are usually more reliable than other oscillators. This is because the volume measuring component of the indicator leads the price action.

The divergence in this case would be to look to see where the peaks and troughs of price action deviate from the peaks and troughs of the On Balance Volume. Trend lines are used to connect the peaks and troughs of both price action and the OBV. Whenever a divergence is detected, it represents a trading opportunity as price action will follow the divergent movement of the OBV indicator. There are two types of divergences: bullish and bearish divergence.

The bullish divergence occurs when OBV shows a higher low as prices move show lower low. A bearish divergence occurs when OBV forms lower lows when prices forge higher highs. The increase in volume of the OBV is mostly that of institutional traders so price action is sure to follow the OBV’s direction.

OBV_diverg

The example above shows a typical divergence trade. The OBV is showing lower lows while the price action highs are static. This is a bearish divergence and price is expected to correct downwards to tally with the OBV. After identifying the divergence, the trade is setup. The exit point of this trade is when price gets to oversold levels as identified by the OBV. Note that a good technical entry is required for this trade to play out as expected.

2) Indicator Breakout

The On Balance Volume indicator can be used to initiate a breakout trade. What is done here is that the previous highs or lows of the indicator are connected by a trend line, and then we look for a move of the indicator line that will break this trend line. When this break occurs, the price action will follow the direction of the indicator breakout.

 OBV_break

Here we can see that the indicator shows a resistance area and the line breaks this area. The price action eventually mimicked this move and we saw price action head upwards in the manner of an ascending triangle breakout.

Conclusion

The divergence trade is the easier of the two strategies to use. Make sure you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management.

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