Part II of Oscillators focuses on On Balance Volume (OBV) and Relative Strength Indicator (RSI).
On Balance Volume (OBV)
In his 1963 book, Granville's New Key to Stock Market Gains, Joe Granville introduced the OBV indicator. To measure positive and negative volume flow, this was one of the first and most common indicators. The theory behind the indicator: price precedes volume. OBV is a simple indicator that adds the volume of a period when the closure is up and subtracts the volume of the period when the closure is down. The OBV line forms a cumulative sum of the volume additions and subtractions. To seek differences or clarification, this line can then be compared with the price chart of the underlying security.
As mentioned above, OBV is determined when the security price closes up and subtracts the volume when it closes down by adding the day's volume to a running cumulative sum.
- For instance, if the closing price was higher today than the closing price yesterday, then the new closing price is higher: OBV = Yesterday's OBV + Today's Volume
- If the closing price is lower today than the closing price yesterday, then the current OBV = Yesterday's OBV - Today's Volume
- If the closing price today was equivalent to the closing price yesterday, then the current OBV = Yesterday's OBV = Yesterday's OBV = Yesterday's OBV
The principle behind the OBV indicator is that price adjustment would precede changes in the OBV. A growing amount can indicate the existence of "smart cash" flowing into a security. Then, if the public follows suit, the price of protection will also increase. The OBV indicator, like other indicators, will follow a path. An increasing (bullish) line of OBV shows that the amount on days up is heavier. The OBV will serve as a confirmation of the price uptrend if the price is also rising. In such a scenario, the rising price is the product of higher security demand, which is a prerequisite for a healthy upward trend.
However, a negative divergence is present if prices are going higher when the volume line is dropping. This difference means that the trend is not healthy and should be taken as a warning sign that the pattern will not continue. It is not necessary to have the numerical value of OBV, but rather the direction of the line. A consumer should focus on the OBV trend and its relationship with the price of protection.
Relative Strength Indicator (RSI)
A widely standard momentum indicator created by J Welles Wilder in 1978 is the Relative Strength Indicator (RSI). The name of the RSI is somewhat misleading as the relationship between two markets, or securities is not contrasted, but rather the internal strength of a single security. "Internal Strength Index" would have been a more fitting term. The RSI is an 'overbought/oversold' measure in theory, but its actual application, as described below, is much more varied in practice.
It is expressed as (rather than being positive or negative) a number between 0 and 100. If the RSI increases to a level of about 70 or higher, this implies that the market may be overbought, which means that one should be wary about buying more and searching for selling opportunities. If the RSI falls to about 30 or below, this implies that the market may be oversold, which means that one should be wary about more selling and searching for buying opportunities.
The RSI estimate is based on the ratio of the average number of days in which the price increases to the average number of days in which the price falls.
RSI = 100 - (100 / (1 + RS))
RSI has been broken down into its fundamental components to simplify the explanation: RS, Average Gain and Average Loss. This estimation of the RSI is based on 14 periods, which is the default that Wilder suggested in his book. Losses are expressed as values that are positive, not negative.
The first 14 cycle averages are the very first estimates for average gain and average loss:
- First Average Gain = Total of Gains during the past 14 periods / 14
- First Average loss = Total of Losses during the past 14 periods / 14
The second and subsequent figures are based on the previous averages and the present loss of profit:
- Average Gain = [(previous Average Gain) x 13 + current Gain] / 14
- Average Loss = [(previous Average Loss) x 13 + current Loss] / 14
A smoothing strategy close to that used in the exponential moving average calculation is the taking of the prior value plus the current value. This also implies that, as the total measurement time extends, RSI values become more accurate. With his formula, Wilder normalized RS and turned it into an oscillator which fluctuates between zero and 100. In consequence, an RS plot looks precisely the same as an RSI plot. This step of normalization makes it simpler to define extremes since RSI is bound by range. RSI is 0 when zero is equal to the Average Gain.
Assuming a 14-period RSI, this suggests that prices have declined in all 14 periods. No gains were available to calculate. RSI is 100 when zero is equal to the average loss. This implies that rates have declined in all 14 periods. No damages had to be assessed.
The techniques of the RSI oscillator are very similar to the MACD. They should also be analyzed in combination with other RSI signals, as well as the price action analysis underlying them. The principle of confirmation and divergence in technical research remains essential.
- Overbought and oversold situations constitute historical lows and highs. Such levels are used as an early warning sign by seasoned practitioners that a top/bottom could be forming. The 0 and 100 RSI parameters mean that it is possible to stipulate absolute overbought and oversold amounts. Movements over 70 and below 30 are generally considered to be prolonged, but a change to 80 and 20 may be made in healthy trending market conditions.
- Another early indicator that the market is losing directional momentum and a turning point may be coming are the divergence of the RSI relative to underlying market movements. New highs or lows can still be generated by the underlying market, whereas the oscillator struggles to hit new highs/lows at the same time. Divergence is accurate and efficient only when occurring at market levels that are prolonged (above 70 and below 30).
- When a top (or bottom) fails to surpass a previous extreme on the RSI and then reverses, and this results in failure swings.
- The levels of support and resistance are often shown more clearly than on the price chart.
- An early warning via trend lines and formations about market breaks. The RSI oscillator may also be subject to the same rules relating to trend lines and formations that are valid on an underlying price map. The subsequent oscillator breaks may confirm the price action and, in some instances, even precede, as an early warning, the corresponding change in the underlying market.
The most common oscillator among technical analysts, possibly. In most other oscillator tests, the estimation formula guarantees quantifiable overbought and over-sold amounts that are a weakness. The smooth and less erratic movements produce an analysis-friendly method that enables analysis of the trend line and formation.
Thank you for reading and hope you have a good rest of the day!
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