ON BALANCE VOLUME

In our last several "Inside the Black Box" articles I have argued that swing traders often pay too much attention to price and not enough to volume. Certainly, it is price that rewards us for an astute trade and penalizes us for a less accurate one. Volume does not put money into or take funds out of our brokerage account.

Yet as I have tried to demonstrate, swing traders overlook volume at their peril. Volume should be an indispensable part of the analysis of every price pattern. Astute swing traders should pay particularly strong attention to volume on breakouts, climactic bottoms, and spikes after sustained uptrends. Volume divergence, when price is rising but volume is trending down, is a strong warning that price itself will likely soon fall.

Joseph Granville, creator of the On Balance Volume indicator, shares this same insistence on the importance of volume analysis. He exclaims that volume precedes price, and he even goes so far as to argue that volume is cause and price is effect.

The indicator he designed to track the flow of volume in and out of a stock or index is called "On Balance Volume," or OBV. OBV is a running total of volume. Designed in the early 1960s, before computers were used in stock analysis, its calculation is simple. An arbitrary number (usually a very large one) is used to begin an OBV line. On days when price closes higher, all the volume of that day is added to this line. On days when price closes lower, the volume is subtracted from the line.

For example, let's say that XYZ went from $20 to $21 in a day and traded 100,000 shares. The next day it retreated exactly to $20, but traded only 50,000 shares. Even though price stayed the same for the period, the OBV line would have increased by 50,000 -- the difference in trading volume between day #1 and day #2. If this same pattern were to repeat itself for several days in a row, then the security's price would remain constant, yet it would have a rising OBV line. Granville would argue that this situation is highly bullish. The On Balance Volume Line is rising even though price is staying the same. Eventually, he would argue, this hidden demand will surface and will force prices higher.

An OBV line typically takes the form of a zig-zag. It can trend up (a bullish sign), down (a bearish sign) or sideways (in which case the OBV trend is doubtful).

When analyzed in conjunction with the price chart, the OBV line can do one of three things. First, it can confirm the price movement, trending upward as prices rise. Second, it can diverge bullishly or bearishly from price. A bearish divergence would occur when prices hit a new high, but the OBV line makes a lower high. A bullish divergence occurs when prices hit a new low, but the OBV line makes a higher low. Finally, the OBV line can act as a leading indicator. If OBV breaks out to a new high, but price is below the previous high, then the probability is that prices will follow it to higher ground. Swing traders can analyze OBV by examining trendlines and moving averages.

The three-month chart of grocery chain Albertson's (ABS) shown below illustrates the importance of OBV analysis. In the period marked "1," ABS began an uptrend that took the shares from $19 to $23. The OBV line mimicked the price trend and rose steadily to a peak along with price in early September.

In early September ABS moved about $1.50 -- a huge amount for this stock -- on a volume spike. (For more on volume spikes, please visit our issue archives.) For two more days prices rose. Look carefully, however, at the OBV pattern that is circled and is marked "2." Note that there was bearish divergence as price hit a new high, but the OBV line was slightly lower. Note also that a trendline drawn on OBV broke before the trendline on price.

As Albertson's shares declined into mid-September, the OBV indicator also trended lower. In the period marked "3," note, however, that there was bullish divergence. Prices trended lower, but the OBV indicator went higher, implying that the stock would reverse in price.

As the chart ends in the period marked "4", ABS is well below its early September high. The OBV line is testing is previous high. A breakout into new high ground by OBV implies that prices should trend higher. For this reason, as well as several others, I flagged Albertson's as a "Stock to Watch" in today's newsletter.

Many technical analysis tools (such as moving averages) are referred to as "lagging indicators" because they describe changes in pattern after the fact. OBV is one of the few tools that can serve as a leading indicator. When it diverges from the underlying price action, its message should be taken very seriously.

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