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The theory of On-Balance Volume (OBV) was developed by Joe Granville and forms the basis of his timing system.
OBV is the cumulative total of advancing and declining volume. It is calculated by adding the daily volume to the cumulative total if the stock closes higher than the previous day, or subtracting it if the stock closes lower. (No change days are ignored.) Absolute values in OBV are meaningless, but a graph of OBV movement is very useful for spotting divergences in OBV and price.
Advance-Decline Volume (ADV) is a variation of OBV used when both advancing and declining volume are available for the same day. I know of no source of this type of detailed data for stocks; however, advancing and declining volume are reported daily for major exchanges. Decision Point calculates and tracks ADV for several major market and sector indexes.
Decision Point also tracks the individual stocks in the S&P 500, S&P 100, NASDAQ 100, and DJIA. At the end of the day the volume for advancing stocks is counted as advancing volume and volume for declining stocks is counted as declining volume. Then these numbers are combined to arrive at an aggregate OBV for the given market index.
Interpretation of OBV and ADV charts are the same, and further reference to OBV should be taken as a reference to ADV as well.
Divergences in price and OBV (also called non-confirmations) are important events which warn that a change of price trend is likely. An example of a negative divergence (which predicts lower prices to come) would be for the stock to hit a higher price high that is not confirmed by corresponding new high in OBV. A positive divergence (which predicts higher prices to come) occurs when a lower price low is accompanied by a higher low on the OBV chart. In these cases it can be said that volume is leading price, but this is not always the case.
The divergences described above are associated with a drying up or decrease in volume commonly associated with price tops and bottoms; however, tops and bottoms can also be accompanied by high volume activity ("blow-off" tops and panic selling near bottoms). In this case, at a top you would observe a higher ADV top accompanied by a lower price top. At a bottom you would observe a lower OBV bottom accompanied by a higher price bottom. In these cases volume does not lead price as is generally accepted.
Simply stated, any OBV divergence near a top is considered negative and any OBV divergence near a bottom is considered positive.
The amount of time separating the divergence (the horizontal distance between the tops or bottoms) is also important. It is my observation that a separation of between two to 18 months (more or less) is the most significant.
Finally, let me caution you regarding extremely high volume days. Occasionally an event will occur that in a single day causes a stock to trade at volume levels that have no relationship to reality. This can cause massive divergences to occur, but it is my opinion that the data is now distorted and should be ignored.
NET ADVANCE-DECLINE VOLUME
The display of daily Net A-D Volume on the chart above highlights extreme (climactic) activity. When a large number of stocks are participating in a particular price move (up or down), we recognize that such high levels of participation are unsustainable and refer to it as a "climax".
There are two kinds of climaxes -- an initiation climax, which marks the beginning of a longer-term price move and an exhaustion climax, which marks the end of a price move. Both kinds of climax can be followed by some consolidation activity before the trend changes or continues.
Climactic indicator readings identify points at which the market is overbought or oversold, but they don't always mean that the trend is about to change directions.
DOLLAR-WEIGHTED A-D VOLUME
A variation of OBV is to calculate a dollar-weighted version. This is done by multiplying the daily volume of each stock in a given market index by the closing price, then adding (or subtracting, if the stock closes down) the result to the cumulative total for the index. Decision Point tracks daily dollar-weighted volume indexes for the S&P 500, S&P 100, NASDAQ 100, and Dow Jones Industrial Average.