The on-balance volume is a classic indicator that has helped trend followers determine the strength of a trend for over 50 years. If you are trading trends, you should know and use the on-balance volume, too.
What is the on-balance volume?
To calculate the on balance volume, you simply add the volume of all periods with rising prices and subtract the volume of all periods with falling prices. The result is plotted as a graph below the regular price chart.
That’s it. One of the advantages of the on balance volume is its simple calculation process. This simplicity helps traders to understand the significance of the on balance volume: If the market is rising, the volume will be added to the on balance volume. If the market is falling the volume will be subtracted from the on balance volume.
In other words, when the market is rising, the on balance volume should rise, too, and vice versa. The on balance volume should mirror the market. In an intact trend, that is exactly what is happening. Therefore, a parallel movement of on balance volume and the market is considered a validation of the trend.
Sometimes, however, the market will form a new high (in an uptrend) or a new low (in a downtrend) without the on balance volume reaching a new high / low, too. This is a sign the trend is in trouble. What happened? In this case, the new market high / low was created with significantly less volume than the preceding high / low. Therefore, the on balance volume did not move past its past extreme.
The low volume during the new extreme indicates that less and less traders are investing in the direction of the trend. Currently, there were still enough investors left to push the market to a new extreme. Sooner or later, however, the trend will be lacking this power. Then, the trend will be over.
How to use the on balance volume for your trading
As a trend follower, you need to know if you can still trust a trend. The on-balance volume is one of the most popular ways to determine exactly that.
In its most simple form, you could use the on balance volume to keep investing in the continuation of a trend as long as the on balance volume matches the movement of the market price.
Most traders choose to monitor the on balance volume manually. Theoretically, programming an expert advisor for Meta Trader would be possible, too. Recognizing trends by using machine code, however, is somewhat hard to do. To program such an expert advisor, you would need more advanced programming skills than most traders have.
Additionally, you could use the divergence between the on balance volume and the market’s movement as an indication for an impending turnaround. You would have to combine the on balance volume with another indicator, for example candlestick formations, to determine the exact timing for your investment.
Limitations of the on balance volume
Be aware that the on balance volume has some inherit weaknesses. When the market moved with a relatively high volume in the past, the on balance volume can fall, even though the current volume remains constant.
Since the on balance volume uses a constant number of periods for its calculation, with every new period, a period will get eliminated from the calculation, and the new period will be factored in. If the market moved in the same direction during both periods, the on balance volume will move further to its extremes.
In other words: In that case, the on balance volume simply compares the volume of two periods. If the volume of the new period is higher, the on balance volume will move in the same direction as both periods. If the volume of the old period is higher, the on balance volume will move in the opposite direction.
Basing a trading decision on such a random event can have hazardous consequences. To avoid this problem, traders came up with newer volume-based indicators that avoid this problem. The most prominent example of these advanced, more recommendable indicators is the money flow index (MFI).