What is the On-Balance Volume (OBV) Indicator?

Trading cryptocurrency requires a comprehensive strategy, and traders always look for tools that can be helpful. Although candlestick charts and price charts are valuable, they might not provide all the information. Therefore, traders utilize volume indicators for detailed market analysis, such as the On-Balance Volume (OBV) indicator.

The OBV indicator is a well-established technical tool that helps users gauge the strength of market trends. It is a valuable indicator for identifying price trends, spotting divergence, and detecting breakouts.

Let’s explore how to interpret and use the OBV indicator to make informed decisions in cryptocurrency trading.

Understanding the On-Balance Volume (OBV) Indicator

The On-Balance Volume (OBV) indicator was developed by Joseph Granville in 1963. It is a trading indicator that leverages volume to determine the price movement of an asset. According to the basic theory of the indicator, institutional investors lead in buying and selling assets before others, which is reflected in the volume of their transactions. This means that changes in volume can potentially lead to changes in the price of an asset.

OBV is a compounding indicator that measures the purchasing and selling pressure of an asset. It adds volume on up days and subtracts it on down days. When the price of an asset closes higher than its previous close, the day’s volume is considered up-volume that is added to the OBV. On the other hand, when the asset’s price closes lower than its prior close, the volume is considered down-volume and is subtracted from the OBV. This calculation generates the OBV line, which you can plot alongside the price chart.

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How does the OBV Work?

The On-Balance Volume indicator tracks the cumulative volume of an asset by considering whether its price is trending upward or downward. It is calculated by adding or subtracting the volume of each trading period, depending on whether the price closed lower or higher than the previous trading period's closing price.

It can be calculated in the following ways:

• If today’s closing price is higher than the previous closing price: OBV = Current Day’s Trading Volume + Previous OBV
• If today’s closing price is below the last closing price: OBV = Previous OBV - Current Day’s Volume
• If today’s closing price is equal to the previous closing price: OBV = Previous OBV

Let’s explore an example of the OBV indicator for over five days to see how the cumulative total is calculated.

• Day 1: Suppose the starting OBV is 0. The 24-hour closing price of an asset is $60,000 with a volume of 200. The OBV remains zero since there is no previous day's price for comparison.
• Day 2: Suppose the last 24-hour closing price is $61,000, and the volume is 300. The new OBV will be 0 + 300, which equals 300.
• Day 3: Suppose the price closes lower at $60,500, with a volume of 150. The new OBV will be 300 - 150, which equals 150.
• Day 4: Suppose the price closes higher at $62,000, and the volume is 400. The new OBV will be 150 + 400, which equals 550.
• Day 5: Suppose the price closes similarly at $62,000, but the volume is 100. The new OBV will be 550 with no changes.

Significance of the OBV Line

The OBV line will better determine market trends, which traders often prefer. It makes the following predictions that increase its importance.

• An upward trend is likely to continue when the price and OBV make higher peaks and higher troughs.
• A downward trend is likely to continue when the price and OBV make lower peaks and lower troughs.
• When the OBV is rising during a trading range, accumulation may occur, indicating a potential upward breakout.
• When the OBV is falling during a trading range, distribution may occur, signaling a potential downward breakout.
• An upward trend is likely to stall or fail when the price continues to make higher peaks and the OBV moves in the opposite direction.
• A downward trend is likely to end when the price continues to make lower troughs and the OBV moves in the opposite direction.

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Using the OBV Indicator in Crypto Trading   

The cryptocurrency market is highly volatile, making volume analysis even more significant. A sudden change in the price of a digital asset can be temporary, but a rise or fall in volume could signal the beginning of a new trend.

The signals provided by the On-Balance Volume indicator can play a central role when trading cryptocurrencies. It can help you in the following ways:

1. Confirm Trend Strength

The On-Balance Volume indicator confirms the strength of a trend when aligned with the price direction.

Traders can look for the following scenarios:

A rising OBV indicates that buyers are more active than sellers, and volume is accumulating. In such a situation, you can expect the price to move higher. So, when the OBV indicator rises in tandem with the price, it can be taken as confirmation of the bullish trend. It suggests opportunities for opening long positions.

Conversely, a falling OBV indicates that sellers are more active than buyers, and volume is distributed. This way, you can expect the price to fall. Therefore, when the OBV falls with the price, it confirms a bearish trend, making it a good time to consider short positions.

2. Spot Trend Reversal

Another powerful signal provided by the On-Balance Volume indicator is spotting potential trend reversals.

When the price makes lower lows and the OBV line makes higher lows, it signals that selling pressure is decreasing despite falling prices, indicating a potential buying opportunity and a bullish divergence (a trend reversal to the upside).

On the other hand, if the price makes higher highs and the OBV line makes lower highs, it signals a weakening buying pressure and a potential sell-off, indicating a bearish divergence (a trend reversal to the downside).

3. Validating Breakouts

The OBV indicator helps traders validate breakouts when trading digital assets, enabling them to avoid fakeouts. A valid breakout confirms that a price breakout is genuine and not a false signal before you enter a trade. A breakout occurs when the price of a cryptocurrency moves beyond a key level, such as support and resistance or a trendline.

You can check the OBV line when the value of a cryptocurrency breaks above a key resistance level. A rising OBV indicates that the breakout is supported by strong buying interest, suggesting the new price level will be sustained. However, if the OBV line is falling or flat, the breakout may be a fakeout.

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Limitations of the OBV Indicator

The OBV indicator provides valuable information when the price of a digital asset is either trending upward or downward. However, when the market is ranging or moving sideways, relying solely on the OBV indicator would not be helpful.

The On-Balance Volume indicator has the following limitations.

• The OBV indicator is based on historical price and volume data. It means that it can sometimes lag when a sudden price change happens.
• The indicator may not be suitable for day traders, as it typically performs poorly when the market is ranging.
• A single day's significant price movement, due to a news event or a large institutional trade, can result in a substantial change in volume. This can dramatically skew the OBV line, causing the indicator to be inaccurate for a short period.

Final Thoughts

The On-Balance Volume (OBV) indicator can be a valuable addition to your toolkit. By understanding how to interpret its signals, you can make informed decisions by confirming trend strength, identifying trend reversals, and validating breakouts. However, like other technical tools, the OBV indicator has its limitations; therefore, it should always be used with caution and proper risk management in place.

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