by Wayne A. Thorp, CFA

The study of technical analysis focuses primarily on price and volume. Perhaps it is not surprising that price garners most of the attention. However, volume deserves more than a cursory glance.

Volume is important because it provides information about the strength (or lack thereof) of price movements.

Heavier volume should be in the direction of the existing trendvolume should be relatively higher on up days during an uptrend and on down days during a downtrend. Furthermore, price movements on heavier-than-normal volume are more apt to continue than those with light(er) volume.

One of the more useful technical indicators used by technicians is on-balance volume ( OBV). which was introduced by Joseph Granville in his 1963 book Granvilles New Key to Stock Market Profits. OBV takes volume analysis beyond the volume bars typically seen below a price chart and provides a visual representation of the volume flow for a given security, enabling you to compare it against the price action.

Calculating OBV

One reason for OBVs popularity is its broad applicationstocks, futures, options, indexes, and markets. It is also relatively easy to calculateas long as you have price and volume data for the period you wish to analyze, you can create the OBV. The value of the OBV is strictly arbitrary: The day you begin calculating the OBV determines the initial value. What is of greater importance, however, is the trend and direction of OBV.

To calculate the OBV, you begin by comparing the closing price of one day to the closing price of the prior day:

If the price is higher than it was the prior day, then all of that days volume is added to the previous days volume;

If the price is lower than previously, the days volume is subtracted from the previous days volume;

If the price has not changed from the prior day, the days volume is ignored.

Table 1 shows you how to calculate the OBV using daily data for General Electric for the period February 28March 16, 2001. However, most technical analysis programs include OBV in their selection of technical indicators.

Smart Money vs. the Public

When Granville introduced OBV, he argued that the market is divided into two groupssmart money (made up of large investors and traders), and the general public. The smart moneyarmed with better informationis able to buy securities at a lower price than the public. Granville theorized that, during bull markets, the smart money bids up prices and participates in buying for the majority of the upward price move. Once the smart money is fully invested, these investors wait for the final segment of the move. This is fueled by the general public who, after taking note of the upward move in price, jump on the bandwagon and continue to bid up the price. However, the general public is buying shares from the smart money, who is now selling their shares and reaping the gains. When the general public realizes what is taking placemainly that the price is in free-fallthey rush to sell, further depressing the price. Therefore, in order to successfully use OBV, the division of the market between smart money and the general public must exist. The smart money must have someone from which to buy and which to sell, which is where the general public enters the picture.

Measuring Fundamentals