Volume is one of the best tools that an investor or trader can use to tell whether money is moving into or out of a stock
Joseph Granville's "New Strategy of Daily Stock Market Timing for Maximum Profit". Joe developed the OBV as a way to determine whether the smart money was buying or selling. It is calculated by keeping a running total of the volume figures and then adding in the volume if the close was higher than the previous period, or subtracting the volume if the closing price was lower.
The most basic level of OBV analysis is to determine whether it is following the price behavior. In other words, in an uptrend the OBV should be keeping pace with prices or leading prices higher. In a downtrend, both the OBV and price should be making a series of lower highs and lower lows.
One of the most simplistic ways to use the OBV is to see if it makes a new high with each price high in an uptrend, or makes a new low with prices in a downtrend.
The OBV stresses the importance of volume and its relationship to the price and momentum of any given stock. Not only did the indicator consider volume, but also whether volume was pushing prices up or down.
The actual OBV value isn’t important, since the number can be huge, near zero, negative or positive. Therefore the right axis of the OBV indicator can be ignored; what matters is how OBV is acting, and its trajectory.
Fundamentally, OBV indicator compares the positive and negative volume flows of a stock against its price over a time period. When a stock closed higher than its previous daily close, then all of the day's volume was considered as up-volume. Whereas, if a stock closed lower than the previous daily close then all of its day's volume was considered down-volume. The cumulative total of the positive and negative volume flows then formed the OBV line.
The OBV should rise when price is rising, and fall when price is falling.
If the market started to heavily buy a stock then the increased volume would force the OBV line to climb which in turn would drag the price higher.
If the OBV shows higher consecutive peaks and troughs then a Bull channel is in session whereas if it indicates lower consecutive highs and lows then a Bear channel is predominant
Granville's studies indicated that changes in the direction of the On-Balance Volume indicator forecasted potential reversals in price direction.
Divergence is a warning signal, and occurs when the price is trending higher but OBV is either flat or dropping overall, or when the price is falling but OBV is flat or rising overall.
As divergences show, OBV can act before price, also making it a useful tool for indicating in which direction a price breakout could occur.
To provide further confirmation that a trend may be weakening, Granville recommended using a 20 period moving average in conjunction with the OBV. As a result, OBV users could then observe such events more easily by noting any crossovers of the OBV line and its moving average.
If the price and OBV are both in the same trend movement and the OBV begins to breakout then this is again signs of a new trading opportunity. These events can best be confirmed by noting any crossovers of the OBV and its moving average.
Granville believed that a change in volume direction, reflected by the OBV, will always occur before the price changes direction. Unfortunately, it’s not that easy; while the OBV may help forecast many reversals, it often does so because it forecasts too many, providing a large number of false signals along with the valid ones.
Another limitation of the OBV indicator is that a massive volume spike day can throw off the indicator for months. An earnings announcement, index rebalancing or institutional block trade can cause the indicator to spike or plummet, but the volume spike may or may not be relevant information.