Improving A Classic Momentum Indicator's Abiilty To Time Stock Entries

Having a stable of trading tools that helps you timing when to buy stocks will drastically improve your trading profits

. However, many traders, particularly novice traders, suffer from paralysis by analysis. There are simply too much data, too many strategies, and too many indicators for any trader to completely master.

Implementing volume centric momentum indicators provides you several key benefits, none the least of which is simplicity of reading. Momentum indicators tend to be very simple to interpret, and can provide traders important insight into market trends,

On Balance Volume (OBV)

On balance volume is a momentum indicator that was created by Joe Granville in 1963. The on balance volume indicator is designed to measure positive volume flow. The key concept to understand is that volume preceeds price, and as such, measuring the flow of volume (into or out of a stock) provides traders a leading indicator on market trends.

On Balance Volume is constructed as a running total of volume flow. Volume is added to the total when price closes to the upside, and subtracted from the total when price closes to the downside. This is a key concept that the indicator is based on closing prices, I'll discuss why in a moment.

Traders use the OBV indicator to find divergences between volume and price.

The definition of divergence as supplied by StockCharts.com

A situation that occurs when two lines on a chart move in opposite directions vertically. People often look for divergences by comparing a stock's direction to the direction of its RSI, its MACD or its Stochastic Oscillator. There are two kinds of divergences: positive and negative. A positive divergence occurs when the indicator moves higher while the stock is declining. A negative divergence occurs when the indicator moves lower while the stock is rising.

A divergence between On Balance Volume indicates that 1) insitutional traders are taking profits, 2) volume is not supporting the current trend, and 3) that momentum is fading.

A divergence in OBV opposing the direction a trader is looking to enter a stock is a warning signal against entry. OBV sloping positively in the direction of your trade would provide confirmation of your entry.

Strengths and Weaknesses of On Balance Volume

Ease of reading is a key element of the OBV indicator. There is no mistaking whether or not OBV has a postive or negative slope. Thus, it is a great indicator in that it doesn't give many false signals.

OBV requires a full periods volume. In other words, the indicator can not include the current days (or whatever chart period used by the trader) data to construct the indicator until the end of that period. Since OBV includes volume directly in its formula, it does not gracefully handle gaps Number 2 is a significant weakness on OBV, as gaps can represent a significant occurence in fundamental data or news, such as earnings releases.

Tom Bierovic addressed these weaknesses when he created his own indicator: On Balance True Range.

On Balance True Range (OBTR)

When Bierovic explains his indicator, he explains that there is a strong relationship statistically between volume and price. There have been many studies of this premise, most notably the MIT Laboratory for Information and Decision Systems report: Relationship between Trading Volume and Security Prices and Returns.

True Range

The first component of the OBTR momentum indicator is called True Range. True Range. True Range, as defined by J. Welles Wilder is:

True Range (TR) which is defined as the greatest of the following:

The current High less the current Low. The absolute value of the current High less the previous Close. The absolute value of the current Low less the previous Close. If the current high-low range is large, chances are it will be used as the True Range. If the current high-low range is small, it is likely that one of the other two methods would be used to calculate the True Range. The last two possibilities usually arise when the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move). To ensure positive numbers, absolute values were applied to differences.

As you can see, true range is a measure of price movement, and, as stated before, is highly related to volume. Mr. Bierovic simply replaced the Volume component of OBV with True Range, to create On Balance True Range.

OBTR addresses the two weaknesses in OBV. First, OBTR is always up to date, and second, gaps are handled properly in this indicator.

OBTR can be combined with a 9 day moving average (EMA) to create buy and sell signals. A bullish signal occurs when OBTR crosses above the EMA, and a bearish signal is generated when OBTR crosses below the EMA.

Combining OBTR with MACD

Combining OBTR with a dual MACD system can be a very powerful set of indicators for determining price entries (when to buy stock), and exits (when to sell stock).

A 12,26,9 MACD is combined with OBTR for buy signals. Look for bullish divergence between price and the OBTR, and bullish cross overs in both the MACD and OBTR for entry points.

A 19,39,9 MACD is combined with OBTR for sell signals. Wait for the MACD to display a bearish cross, or cross below the 0 line, and confirm this signal utilizing OBTR bearish divergence or crosses.

by: Steve Warshaw

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