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VOLUME-BASED INDICATORS
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Traders can use several technical indicators to help them analyze volume. Some traders track a 5-day exponential moving average of volume. Its slope identifies the trend of volume (see Sections 25 and 32). Others use On- Balance Volume and Accumulation/Distribution.

On-Balance Volume

On-Balance Volume (OBV) is an indicator designed by Joseph GranviUe and described in his book, New Strategy of Daily Stock Market Timing. Granville used OBV as a leading indicator of the stock market, but other analysts have applied it to the futures markets.

OBV is a running total of volume. It rises or falls each day, depending on whether prices close higher or lower than on the previous day. When a stock closes higher, it shows that bulls won the day's battle; its volume on that day is added to OBV. When a stock closes lower, it shows that bears won the day, and that day's volume is subtracted from OBV. If prices close unchanged, OBV stays unchanged.

On-Balance Volume often rises or falls before prices — it acts as a leading indicator. As Granville put it, "Volume is the steam that makes the choo- choo go."

Crowd Psychology

Prices represent the consensus of value, while volume represents the emotions of market participants. It reflects the intensity of traders' financial and emotional commitments, as well as pain among losers (see Section 32). OBV is a running total of volume. It tracks changes in traders' involvement in the market and the intensity of their pain.

A new high in OBV shows that bulls are powerful, bears are hurting, and prices are likely to rise. A new low in OBV shows that bears are powerful, bulls are hurting, and prices are likely to fall. When the pattern of OBV deviates from the pattern of prices, it shows that mass emotions are not in gear with mass consensus. A crowd is more likely to follow its heart than its mind. This is why changes in volume often precede changes in prices.

Trading Signals

The patterns of OBV tops and bottoms are more important than the absolute levels of this indicator. Those levels depend on when you start to calculate On-Balance Volume. When OBV rises or falls together with prices, the trend is confirmed. If prices reach a new high and OBV reaches a new high, the uptrend is likely to continue. If prices reach a new low and OBV falls to a new low, the downtrend is likely to continue. It is safer to trade in the direc­tion of a trend that is confirmed by OBV (Figure 33-1).

1. When OBV reaches a new high, it confirms the power of bulls, indicates that prices are likely to rise even higher, and gives a buy signal. When OBV reaches a new low, it confirms the power of bears, calls for lower prices ahead, and gives a signal to sell short.

If prices rally, sell off, and then riseTo a new^ltgrT,"but OBV rallies to a lower high, it creates a bearish divergence and gives a strong sell signal. If prices decline, rebound, and then fall to a new low, but OBV falls to a more shallow bottom, it traces a bullish diver­gence and gives a strong buy signal. Long-term divergences are more important than short-term divergences. Divergences that develop over the course of several weeks give stronger signals than those that last only a few days.

When prices are in a trading range and OBV breaks out to a new high, it gives a buy signal. When prices are in a trading range and OBV breaks down and falls to a new low, it gives a signal to sell short.

More on OBV

One of the reasons for Granville's success in his heyday (see Section 6) was that he combined OBV with two other indicators — the Net Field Trend indicator and the Climax indicator. Granville calculated OBV for each stock in the Dow Jones Industrial Average and rated its OBV pattern as rising, falling, or neutral. He called that a Net Field Trend of a stock: It could

be +1, -1, or 0. Climax indicator was a sum of the Net Field Trends of all 30 Dow stocks.

When the stock market rallied and the Climax indicator reached a new high, it confirmed strength and gave a buy signal. If the stock market rallied but the Climax indicator made a lower top, it gave a sell signal.

You can view the Dow Jones Industrial Average as a team of 30 horses pulling the market wagon. The Climax indicator shows how many horses are pulling uphill, downhill, or standing still. If 24 out of 30 horses pull up, 1 down and 5 are resting, then the market wagon is likely to move up. If 9 horses pull up, 7 pull down, and 14 are resting, then the wagon is ready to roll downhill.

OBV, the Net Field Trend indicator, and the Climax indicator can be eas­ily programmed on a computer. It would be worthwhile to apply them to a database which includes all stocks of the S&P 500 index. That may produce good signals for trading S&P 500 futures or options.

Accumulation/Distribution

This indicator was developed by Larry Williams and described in his 1972 book, How I Made a Million Dollars. It was designed as a leading indicator for stocks, but several analysts have applied it to futures. The unique feature of Accumulation/Distribution (A/D) is that it tracks the relationship between opening and closing prices, along with volume.

If prices close higher than they opened, then bulls won the day and A/D is positiveTlf prices close lower than they opened, then the bears won and A/D is negative. If price's close where they opened, then nobody won and A/D is zero. A" running total of each day's A/D creates a cumulative Accumulation/Distribution indicator.

A/D credits bulls or bears with only a fraction of each day's volume. That fraction depends on the day's range and the distance from opening to closing price. The greater the spread between opening and closing pricerelative to daily

is credited to the winning camp. The pattern of A/D highs and lows is more important than its absolute level, which depends on the starting date.

When the market rises, most people focus on new highs. But if prices open higher and close lower, then A/D, which tracks their relationship, turns down. It warns that the uptrend is weaker than it appears. If A/D ticks up while prices are down, it shows that bulls are gaining strength

Crowd Behavior

Opening and closing prices are among the most important prices of the day. The opening price reflects all the pressures that have gathered while the market was closed. Openings are often dominated by amateurs who read their newspapers in the evening and trade in the morning.

Professional traders are active throughout the day. They often trade against the amateurs. As the day goes on, waves of buying and selling by amateurs and slow-moving institutions gradually subside. Professionals usually dominate the markets at closing time. Closing prices are especially important because the settlement of trading accounts depends on them.

A/D tracks the outcomes of daily battles between amateurs and professionals. It ticks up when prices close higher than they opened—when professionals are more bullish than amateurs. It ticks down when prices close lower than they opened —when professionals are more bearish than amateurs. It pays to bet with the professionals and against the amateurs.

Trading Rules

When the market opens low and closes high, it moves from weakness to strength. A/D then rises and shows that market professionals are more bullish than amateurs. This means that the market is likely to move higher the following day. When A/D falls, it shows that market professionals are more bearish than amateurs. When the market moves from strength to weakness, it is likely to reach a lower low the following day.

The best trading signals are given by divergences between A/D and prices.

More on Accumulation/Distribution

When you go long or short, following a divergence between A/D and price, remember that even market professionals can go wrong. Use stops and pro­tect yourself by following the Hound of the Baskervilles rule (see Section 23).

Volume Accumulator, designed by Marc Chaikin, is an indicator very similar to A/D. Volume Accumulator uses a mean price for the day instead of the opening price. It is especially useful for those analysts who do not have

access to opening prices. Its trading signals and rules are similar to Accumulation/Distribution.

There are important parallels between A/D and Japanese Candlestick charts. Both focus on the differences between opening and closing prices. A/D goes further than candlesticks by taking volume into account.

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