When futures prices are moving, the amount of pressure being applied to the move is certainly worthwhile information for the trader to know. In futures trading, that pressure is volume, the number of contracts traded during a specific period, and is directly related to the psychology of the marketplace.
The key question is this: How many contracts are traders willing to push in the direction of the price? In other words, how much confidence – or how much fear – do they have in what prices are doing? If they have strong convictions, a logical move would be for them to back up their belief by trading more heavily.
That’s the concept behind the volume indicators, such as accumulation/distribution, discussed in the previous article, and On-Balance Volume (OBV), which is covered in this article. OBV gained its biggest notoriety when, some years ago, Joseph Granville publicized it as an indicator useful for trading stocks. However, research notes suggest that Edward Gotthelf used a similar concept as early as 1948 in developing his Commodex system for trading futures.
OBV is simply a running total of volume. If the close of the current period is higher than the close of the previous period, you add the current period’s volume to the running total. If the close for a period is lower than the close for the previous period, you subtract the period’s volume from the running total. If prices rise on low volume, maybe the bullish forces behind the up move aren’t so strong after all. If prices fall on heavy volume, perhaps the market is more bearish than traders suspected.
In either case, the current volume figure is added to or subtracted from the previous total volume figure for an OBV reading to produce a line indicator that can be compared to price action. As with the accumulation/distribution indicator, the absolute OBV number is irrelevant. It can be any number, depending on the date you started the cumulative volume total. What is important in OBV analysis is the direction of the indicator and its pattern at tops and bottoms relative to the current price trend. Is OBV confirming price action or diverging from the trend?
OBV analysis can be a little trickier in futures than in stocks because futures contracts, especially in financial markets such as stock indices or currencies, have a limited lifespan when volume is sufficient to establish a usable pattern. Generally, if prices are making new highs or lows and OBV is not, you may have a signal about the underlying tone of the market that is telling you prices are not reflecting the true strength or weakness of that market. OBV can move before prices and serve as a leading indicator.
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A case in point is mini-sized Dow futures at the end of April into the middle of May (see chart). The OBV indicator built up gradually from the first of April when the study began to turn down with prices in the first week of May. Then, the sharp 400-point rally in prices in the middle of May caused only a tiny rise in the OBV, which did not reach its April high despite what appeared to be strong price action. The OBV indicator continued to trend downward as prices fluctuated for the next few weeks, reflecting the fact that there just wasn’t enough volume on the price advances to support the price strength shown on the chart and leading to a long price slide.
As has been stressed with all of the other indicators, OBV is not intended to be used alone as a trading signal. Its best use is for confirming what is happening to prices or to give a warning that everything may not be as it appears on the price surface.
