On-balance volume is a method of stock analysis that judges stocks in terms of the volume at which they were traded on a particular day. It is calculated by subtracting the volume of trading that day from a cumulative total if the stock drops or adding the volume if the stock closes up from the previous day. The theory behind on-balance volume, or OBV, is that the volume of trading will precede any price moves. For that reason, if the OBV moves significantly in either direction, investors who believe in its accuracy will buy or sell accordingly.
There are many methods used by investors to attempt to predict stock market trends and movement. Since the prices of a particular stock are usually determined by the volume of trading on that particular stock, it stands to reason that a volume measurement would be an accurate indicator of stock movement. Introduced in 1963 by Joseph Granville, on-balance volume takes the volume-before-price theory and extrapolates from it a reliable metric for investors.
The on-balance volume of a particular stock is a cumulative total, added to on days when the stock price rises and subtracted from when the price drops. It is ultimately unimportant what the actual total of the OBV is on any particular day. What matters is how much the OBV rises or falls and how steep that fall or rise is when charted on a graph. If the slope is steep either way, it means that there was a significant change in the OBV.
Investors then use the on-balance volume in conjunction with the price change to determine if a trend is reliable. Obviously, the price will be rising when the OBV goes up, and vice versa. What investors watch for is how far the price rises or falls in conjunction with the slope on the OBV. In this way, they look either for confirmation of a trend or for the possibility that the trend is misleading.
For example, if a rise in a stock's price is accompanied by a steep upward move of the on-balance volume, it's a good indicator that the trend should continue. This is because the so-called smart money is driving the price change, and the public will soon follow suit. On the other hand, if a price rise is accompanied by just a small jump in the OBV, then it's likely that the trend is weak and could quickly reverse. The OBV works the same way when trying to measure downward trends.