Technical Analysis: Retracing Volume
September 4, 2009
Ask a professional from almost any field of endeavor and they will almost certainly agree that performing the basics well is vital to success. Not only that, basic skills need to be practiced and practiced, constantly. With that in mind, one of the simplest and most widely used technical indicators in the trading world is volume. For good reason, too. Not only does it form a basic part of any market, it can give insights into the flow of capital both in and out of a stock.
On Balance Volume [OBV] is a volume based indicator that combines price movement with an aim to convert that information into a clearer representation of buying and selling pressure. ProfitSource's User Guide describes OBV as follows:
click here to enlarge
The simplest way to use OBV is to look for convergence and divergence. Bullish convergence occurs when stock prices are falling and indicator values are rising. Bearish divergence is the reverse, rising stock prices and falling indicator values. Chart 1 below shows a good example of convergence between OBV and price action. This can be seen by way of the trend lines drawn - the price-based line is decreasing, while the indicator based line is increasing.
Chart 1 - Wave 4 Buy OBV Convergence
click here to enlarge
While the stock moved to a new low, OBV makes a higher low. This indicates that on average the volume on the recent down days has been weaker than the volume on the recent up days. During a downward move, this can often be one of the first indications that a reversal is on the way.
Now as you may have heard before, the biggest challenge faced when trading a retracement is confirming the retracement is in fact over. Realistically this can only be made 100% certain after the fact. However, watching On Balance Volume can often give clues as to how much conviction there is behind a move.
The next chart shows the current progress of the set-up into a new high, giving a good profit so far. Note that bearish divergence has yet to take shape.
Chart 2 - Wave 5 Progress
click here to enlarge
The best way to use OBV with these kinds of retracement-based trades is to compare the direction of the troughs (or peaks) on the stock with the direction of the troughs (or peaks) on the indicator. Both moving in opposite directions over the same period is what you are looking for. Double bottoms (or tops) on the indicator can also be classified as divergence.
Once divergence is spotted, using a technical entry trigger - like a Wave 4 Buy - is the best way to confirm the price has reversed. Then it is simply a matter of defining your exit plans, sticking to them and enjoying the ride. Until next week"
Happy Trading
Jordan Craw
Trading Tutors Team
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