Bloomberg May 1999 87

EQUITY

Most technical indica-tors are built aroundprice movements. TheOn-Balance Volume In-

dicator function, OBV, is a bit dif-ferent. It’s based on both price and volume moves—a relationship thatgives important insights about a mar-ket’s momentum as well as its direction.

Although prices represent a con-sensus of value, volume represents aconsensus of the financial and emo-tional commitment of market partic-ipants. Each trading day in any givenmarket there’s a kind of battle overvalue between bulls and bears, withthe level of intensity of the conflict revealed through the day’s volume.

OBV measures a security’s momen-tum by adding a volume componentto the basic price graph. When pricesclose higher, bulls have won the trad-ing day and volume for the day isadded to OBV. When prices closelower, bears have won the trading day

and volume for that day is subtractedfrom OBV. If prices close unchanged,OBV stays unchanged. OBV is thus a running tally of volume.

How might an analyst read an OBVsignal? “I use OBV for its direction,not absolute level. OBV and pricesusually move in the same direction. I also use it for divergences,” says Fabrice Todeschini, derivatives trad-er at KBC Bank Luxembourg.

In bear markets, cumulative OBVreadings can turn negative. Becausevolumes have different characteristicsand relative levels in stock and fu-tures markets, the absolute level ofOBV is secondary. What really mat-ters are the shape of the OBV lineand its relationship with prices.

You can see how the relationshipplays out. The graph in figure 1—ac-cessed by typing INDU <Index> OBVD <Go> and entering the one-yeardate range 12/31/97–12/31/98—compares Dow Jones Industrial Aver-age price activity with OBV activity forthat period. You’ll see that from earlyJanuary until early April, prices andOBV moved in the same direction,thereby confirming the uptrend.

Now notice the behavior of pricesand OBV from the rest of Aprilthrough the end of July. More pre-cisely, look closely at the triple topson OBV in April—a period duringwhich prices were reaching newhighs. A pattern of three successivetops in a price or OBV line is techni-cally significant because triple topsoften are considered signals of an im-pending reversal in the most recenttrend. “Triple tops or triple bottomsare significant because they show acap or floor on price action. They sig-nal possibilities of a trading range,then the exit of the range in the di-rection of the trend or as a reversal.

TrackingExuberance inaRationalManner

Knowing whether

bulls or bears are at

the helm in any given

market situation

might not be enough;

you also may need

to know how hard

the beasts

are running

By Jean-Marc Bloch

FIGURE 1. Type INDU <Index> OBV D <Go>. Tab down and adjust the daterange fields to graph on-balance volume for the Dow Jones Industrial Averageindex for 1998

88 May 1999 Bloomberg

In technical analysis, there havenever been four tops or bottoms inprices. Volumes through OBV pat-terns reflect these outcomes,” saysMichele Contarini, investment spe-cialist and technical analyst at Ameri-can Express Bank in Luxembourg.That view was borne out, as shown by the ensuing steep decline in theOBV line.

During early May, in this example,prices rallied strongly and the OBVline resumed its upward move, butOBV’s successive highs in early Mayfailed to break the previous highs established in April. This was a verystrong market indication that priceswere fixed in a range.

The Dow actually reached newrecord highs in May but on a muchlower level of OBV than those inApril. This was a yellow warning light.And when a yellow light appears, a red one usually isn’t far behind.When the pattern of OBV divergesfrom the pattern of prices, it indicatesthat market financial commitments

are not in line with marketconsensus on prices.

The best example onthis graph that a diver-gence of OBV and pricesignals a major marketturn can be seen later inJune and into July. The

Dow rallied then while OBV re-mained roughly at the same level—and at lower levels than in the April-May period. This was both a secondstrong deviation and a second warn-ing signal from the market.

In studying this example and otherexamples involving OBV, keep inmind that the pattern of OBV topsand bottoms is of primary impor-tance and that absolute levels of OBVare of secondary importance. WhenOBV rises or falls together withprices, a trend is confirmed and it’ssafer to trade in this direction. WhenOBV reaches new highs, it confirmsthe power of bulls and indicates thatprices might go even higher. WhenOBV reaches new lows, it confirmsthe power of bears, and it hints atlower prices.

The strongest signal is given whenOBV and prices diverge. Obviously,the longer the time frame, thestronger the pattern and the largerthe magnitude of the ensuing movemight be.

In our example with the Dow, wecan define this type of divergence intwo sequences, each of which con-tains two phases.

Sequence 1: April-May• April triple tops on OBV.• April-May shows divergence

between prices and OBV.• Prices are ranging at about 9,000

levels—plus or minus 270 points.• OBV fails to breaks new highs.

Sequence 2: June-July• June prices rally on sideways

pattern of OBV; July’s decline is confirmed by OBV’s direction.

• Prices are rising above 9,000points, reaching new record highabove 9,300.

• OBV is lower than in April.

This decomposition exercise vali-dates the probability of a reversal pat-tern on the Dow. Another analysis of that August divergence is worthhaving a close look at in this regardas well.

Figure 2—accessed by typing INDU<Index> OBV <Go> and using daterange 07/01/98–12/31/98—showsthe bullish divergence in Septem-ber/August through early Octoberfollowed by another spectacular re-versal. The divergence came on Oc-tober 8, when the index fell below itsSeptember 10 low but OBV didn’tfollow, signaling that the low wasn’tbeing made on heavy volume. Youcan easily see symptoms of rationalexuberance’s getting its comeup-pance in this pattern, and you candraw the appropriate lessons for yourown trading. Knowing when money ismoving in and out of a market givesyou a better understanding of yourinvesting risk; it hints at when to takeprofits; and it helps you spot poten-tial losses before they occur.

¬Any comments? Type MAGAZINE<Msge>. For reprints, type MAGZ <Go>.

Jean-Marc Bloch is on the staff of theBloomberg Sales department in LondonFIGURE 2. Type INDU <Index> OBV <Go>. Tab down and adjust the date range

to display OBV levels for the second half of 1998

¬To establish or reset any of the defaultparameters for technical indicators on theBloomberg service, type TDEF <Go>.

Type TDEF <Help> for more information on the function

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