The other alternate idea of a leading expanding diagonal published up to yesterday will be discarded based upon a very low probability.
On Balance Volume was originally developed by Joseph Granville in 1976. Today, it is considered the grandaddy of all volume indicators.
Daily data is accumulated. If price closes higher, then volume for that day is added to the prior total. If price closes lower, volume for the day is subtracted from the prior total. If there is no change in the closing value of price, then OBV does not change.
OBV is used in three basic ways:
1. Confirmation of a trend. If over several time periods OBV moves in the same direction as price, then this confirms a trend. If over several time periods OBV does not move in the same direction as price, then the trend is weak and expect a reversal.
2. Divergence. Between highs and lows, if price makes a new extreme and OBV does not, then it indicates weakness in the direction of price, so expect a reversal.
3. Trend lines. It is my experience that this is the best use of OBV. When price is consolidating OBV will find support and resistance at trend lines. OBV is a leading indicator. If it breaks support or resistance, then the direction of the break from OBV is often a warning that price will break out of a consolidation zone in the same direction.
The example from Gold below illustrates all three ideas.
From July to October 2015, Gold consolidated in a wide price range delineated by the blue horizontal lines of resistance and support. What direction would the breakout be?
The first indication was divergence between the price highs of 24th August and 15th October. While price made a new high OBV did not. This indicated weakness in upwards price movement. Divergence is indicated on price and OBV by green lines.
The final indication came when OBV broke below its pink trend line in 23rd October. Note that this break came prior to the strong downwards movement from price. OBV indicated that price was likely to break out downwards from the consolidation zone and that is what it did.
As price fell strongly from 28th October to about 18th November, OBV also moved strongly lower confirming the price trend. At the end of the trend, OBV again diverged from price. The final low in price at 3rd December did not see a corresponding low from OBV, so this divergence indicated the downwards trend was weak and another consolidation should be expected.
The flip side of the title to this post is “don’t trade against the trend”.
The fact that markets trend is why traders make profits. Price is not completely random. Price tends to move in trends.
Trends are often delineated by trend lines.
When price is consolidating it tends to move in whipsaws about a moving average with choppy overlapping sideways movements. Price tends to move from resistance to support and back again, but not in a straight line. Overshoots of resistance and support can also happen yet price can turn back into the consolidation zone. It is impossible to tell exactly when and where price will turn, so if trying to trade a consolidating market losses are inevitable. Mean reverting systems for trading during a consolidating market are suited for the most experienced and nimble of traders only, not at all for beginners or those with only a few years experience.
When price has been consolidating for a while, then horizontal lines can be drawn to show the upper and lower boundaries of the consolidation zone. It then becomes a waiting game. Waiting for a breakout. When price breaks above resistance or below support on a day with an increase in volume, then a breakout is indicated and the market has begun to trend again.
When price is trending it moves in a clear direction, usually finding support (an upwards trend) or resistance (a downwards trend) at a sloping trend line. The clear direction of price movement is what makes profit easier, so the trick is to identify a new trend early enough to allow for profit to be made and then to identify when it is over early enough to exit the trade with a profit. For less experienced traders, it is advised to wait for a clear trend to be evident and then to only trade in the direction of that trend. Profits should be relatively easy as long as the trend is not exhausted.
If staying with the trend is the easiest way to make a profit, then it makes sense to avoid trading when the market is not trending.
It is often the trades that a trader does NOT take which makes the difference between profit and loss. Cut losses by avoiding consolidating markets.
If there is only one lesson that new traders can learn which will improve trading performance, it is to only trade a clear trend in the direction of that trend.
At any one time a market will be doing one of two things: trending or consolidating. A trader’s approach needs to be different to each type of market. If trend following systems could avoid the whipsaws of a consolidating market, then unnecessary losses can be avoided.
ADX offers a solution. It helps identify which type of market is current.
HOW IT IS CALCULATED
Welles Wilder developed the concept of directional movement in 1978. Directional movement compares two trading periods (usually daily, but it may be used on all time frames).
If price moves higher, the difference between the highs is positive directional movement (+DM). If price moves lower, the difference between the lows is negative directional movement (-DM). Inside days do not result in overall directional movement and so are ignored. Outside days take the larger movement only. The figure below illustrates the idea graphically:
A moving average of +DM and -DM is calculated; the standard time frame is 14 days. This creates the +DX and -DX lines in the ADX indicator.
The +DX and -DX lines can be used in (at least) two ways. Whichever is uppermost indicates the direction of the trend; if the +DX line is above the -DX line the trend is up and vice versa.
When the DX lines cross a potential trend change is signalled. When a market moves from trending to consolidating the DX lines will come close together and fluctuate about each other.
The ADX line (normally black and more solid) is the difference between the two DMs divided by the total of the two DMs. Thus if price is moving strongly in one direction, the numerator will be larger than if price were not moving strongly in one direction:
ADX is bound between 0 and 100. Generally, high and increasing levels indicate a trending market and low and falling levels indicate a consolidating market.
HOW TO USE IT
There are no commonly agreed upon rules, so it is up to each individual trader to test their own rules to determine which approach fits their trading style and preferred market. Below some guidelines are offered as a starting point.
From Dahlquist and Kirkpatrick, “Technical Analysis”:
These general rules for using ADX were originally provided by Ashwani Gujral.
When ADX is rising and at a level:
– Between 15 and 25: Beginning of trending; use trending indicators
– Between 25 and 45: Definite trending; use trending indicators
– At 45 or above: Overextended; watch for trend turning point; use price or indicator patterns
When ADX is declining and at a level:
– Below 20: Low volatility; very short swings; no trend; use oscillators
– Between 20 and 30: Consolidation; use oscillators
– Between 30 and 45: Correction from extreme likely; use patterns; trending indicators
Ruggerio offers the following rules which are a little different (from Kaufman, “Trading Systems and Methods”):
1. If ADX crosses above 25 the market is trending.
2. If ADX crosses below 20 the market is consolidating
3. If ADX crosses below 45 after being higher, the market is consolidating.
4. If ADX rises above 10 on 3 of 4 days after being lower, the market will start to trend.
5. A trend based on rule 4 remains in effect until the 5 day difference in the ADX is less than zero.
Because ADX and +DX and -DX are based on moving averages of +DM and -DM, it suffers from the effect of lag that all moving average systems have. The standard period to average is 14 days, so a new trend will not be indicated until well into the first two weeks of it.
References: Kaufan, P. Trading Systems and Methods; Kirkpatrick, C and Dahlquist, J. Technical Analysis: The Complete Resource For Financial Market Technicians; Pring, M. Technical Analysis Explained.