In this week’s strategy test I take a look at on-balance-volume. Unlike the majority of the technical indicators, on-balance-volume (and accumulation/distribution) uses price as an actionary tab to measured volume; adding volume to a cumulative total on a higher close, but subtracting on a lower close. But how well does it perform as a trading indicator? The basic test looked at buying when on-balance-volume was positive and selling when negative.

Test period: A complete bull-bear cycle defined by the S&P (March 20th 2000 to October 8th 2007).

Stocks: Active Trader list (AAPL BA C CAT CSCO DIS GM HPQ IBM INTC IP JPM KO MSFT SBUX T WMT)

Number of shares: 100

Commission: $9.95 (included in the loss calculation)

Trades: Round-trip only; partial trades were excluded.

As in the earlier stochastic analysis the number of trades executed was very large; just over 1,000 over the 7 year period. This did not make it a very good strategy for commission based trading. The following returns used no stop, although there was very little change in the performance across the 3-8% stop bands:

Total Profit: -$27,492
Winners: 256
Losers: 744
Win percentage: 26%
Profit Factor: 0.71

Although not as damaging, a no-commission based on-balance-volume strategy failed to generate favorable returns:

No stop: TP = -$7,592 on 31% winners
3% stop: TP = -$915 on 36% winners
4% stop: TP = -$672 on 34% winners
5% stop: TP = -$853 on 33% winners
6% stop: TP = -$1,006 on 32% winners
7% stop: TP = +$30 on 32% winners
8% stop: TP = -$2,692 on 31% winners

What of a three test period on no commission?

Over the three test periods of one year starting, with the strong bullish market from 11/2002, a scrappy sideways market from 12/2003, and a volatile bullish market beginning 11/2006, the strategy performed reasonably well. It’s strongest performance came during the volatile bullish market 2006-07 which was somewhat surprising, although may be explained by the higher volume trading common during mature bull markets which may have produced clearer signals; the range of gains for 2006/07 was +$1,710 using a 3% stop to +$5,016 on an 8% stop. The other point of interest was the stronger performance over the mid-stop bands, whereas stochastics and the MACD favored low stops – at least to the extent losses were minimized in the latter two strategies.

However, it’s overall poor performance during the complete bull-bear cycle suggests on-balance-volume should not be used alone as a trading strategy. The strategy – although profitable over the test period, may lull users into a false sense of security.

Last 5 posts by Declan Fallon

• Creating a Trading Strategy in Zignals - November 10th, 2009
• FTSE 250 ETF : Breakdown of 20-day moving average - October 27th, 2009
• NASDAQ Breadth Top-Heavy - September 30th, 2009
• NASDAQ Sep 22nd 2008: 2,179 - Sep 22nd 2009: 2,146 - September 23rd, 2009
• ISEQ Bull Rally - September 16th, 2009