Studying divergences is useful because one can place a position in the opposite direction of price action if there is a divergence with On Balance Volume.
Figure 6 - The AUD/JPY pair in the period covered here has examples of convergence between price and On Balance Volume and both kinds of divergences, bearish and bullish.
1. Normal Downtrend: A normal trend should behave the way the AUD/JPY behaves from February 2nd to February 8th. As price heads downward so does OBV. The shape of the trend is evident in both the price action and the indicator.
2. Bullish Divergence: The downtrend ends in the second half of the 8th. By the 9th the OBV trendline drawn to show the downtrend is violated. One daily session later, price action and the OBV indicator start diverging. OBV inches up as price drops.
- The bullish divergence means that buying pressure is not manifesting itself in the price. On the 15th, price rises and continues doing so for 6 days.
3. Bearish Divergence: Even though the buying pressure from (2) manifests itself, by Feb. 16th investors are not as hot on the AUD. OBV now starts heading down while price is going up. The implication is that the “smart money” is now selling the pair creating a bearish divergence. After a last rally on Feb. 21st, the bears take control of the pair and send it downwards.
The best divergence here is the last bearish one. If one takes a short position before the 21st rally at the vertical line at around 87.50 in 4 sessions the pair has dropped close to 200 pips.
