Chances are great that you opened a financial publication like The Wall Street Journal or visited a website like Yahoo! Finance to read some market internals and stats.
One of these stats is called Advances & Declines.The term “advances” refers to a running cumulative (collective) total of the number of stocks (issues) that have risen in price compared to their close on the previous trading day. So any stock that is currently trades above its closing price from the previous trading day is considered part of the day’s “advances” group.
Conversely, the term “declines” represents a running cumulative (collective) total of the number of stocks that have fallen in price compared to their close on the previous trading day. So any stock that is currently trading below its closing price from the previous trading day is considered part of the day’s “declines” group.
There’s also another part of this stats called “unchanged”, which refers to the number of stocks that trade at exact closing price from the previous day. (Live Chart)
“Advances” and “declines” are also called “advancing issues” and “declining issues”, respectively. In general, but with respect to volume,* the more stocks that are up (advancing) than down (declining), the more bullish the market for that day. Thus, in a rising market, more advances will be recorded, whereas in a falling market, you will usually find more declining issues.
Advancing and declining issues are used as a measure (indicator) of market strength or weakness that we call “market breadth”. It is based on the concept that a strong up-trending or down-trending market is characterized by a large number of stocks advancing or declining moderately in a collective manner, rather than a small number of stocks making large gains or losses.
On days when the advancers roughly equal the decliners it "offsets" any movement in the indexes. Days where the A/D ratio is about 1 to 1 are neutral days regardless of the movement in the indexes. On days when the ratio is 2 to 1, with either decliners or advancers ahead, the A/D numbers are more significant for judging market movements.
When decliners trail advancers, let’s say by a ratio of 2 to 1, we can say that market breadth that day was two-to-one positive and the overall tone of the market is viewed as bullish even if the indexes show little movement. Conversely, when the closing decliners outnumber advancers 2 to 1 or higher, it's often viewed as a bearish indication for the overall market and in the absence of other factors, a strong tone generally will continue.
Based on these daily (and intraday) numbers, an important indicator that we can plot on a chart was developed called the “Advance Decline (A/D) Line.”
How the index is calculated?
Computing the A/D line is straightforward and simple. Each day, we take the number of stocks advancing (increasing) in price on the New York Stock Exchange and subtract the number of stocks that are declining (decreasing) in price. We call the result "net advances" even if it is negative.
=
Positive or negative number
The calculated number is then added to the previous day's A/D Line.
Let me give you an example, on Friday Sep. 4th, 2009 advancing issues ($NYADV – Click for live chart) were 2,444 stocks that closed the day with an increase in their share price. The declining issues ($NYDEC – Click for live chart) were 576 stocks that closed the day with a decrease in their share price.
2444 - 576 = +1868
That means decliners trailed advancers by a ratio of 4.24 to 1 positive and the overall tone of the market should be viewed as bullish especially that the NYSE Composite closed higher that day.
NYSE Net advances (Advance-Decline) Issues - Enlarge
Note: Chart is a capture for Sep. 10 to illustrate the data. Numbers above are for Sep. 4th
For the day, 1868 more stocks closed the day higher than closed the day lower. On the day before, Thursday’s cumulative A/D Line totaled 62444. Today's reading of +1868 would be added to yesterday's total. This would result in an updated total of 64312 to contribute another value to the cumulative A/D line in the chart below, which we will study today.
NYSE Daily Advance Decline (A/D) line "Cumulative"- Enlarge
Note: Changing the above time frame will change the value mentioned above.
Why it’s important?
Many market participants believe the NYSE A/D line is more revealing than popular indexes such as the Dow Jones, S&P 500, or the NASDAQ Composite. This is because the A/D line is usually calculated on the NYSE, which represents the largest equities marketplace in the world. Historically, not only the AD Line peaks out or bottom well ahead of these more widely followed market indexes and averages but also it turns down or up before its own market index turn down or up.
In general A/D line can be used to gauge:
1. Overall market strength.
2. Rising or falling trends.
3. The length and ability of the trend to continue, and
4. The risk of trend change
When thinking about the “AD line” I want you to think of it as a confirmation tool and divergence-warning tool. It is an important indicator to confirm the price of market movements as a whole and detect divergences. Notice that total daily difference between advancers and decliners as well as the value of the A/D line can be positive or negative, which is irrelevant. What is relevant is the direction or the trend of the AD Line and/or any divergence between prices and the AD line.
The A/D line looks at the ratio of advancers and decliners over time. We use it as a measure of breadth of the market in order to determine the strength of market movements to tell us whether bullish or bearish momentum is pushing the stock market.
On days when more stocks advance than decline, the A/D line will move higher signaling that a bullish momentum in the market is increasing. An increasing A/D Line is bullish because more stocks at the NYSE are closing the day with gains. Rising values of the A/D line can be used to confirm the likelihood of the upward trend continuing.
When the A/D line falls, more stocks fell than move higher. A declining A/D line is a sign of internal market weakness, signaling a bearish momentum in the market is strengthening. A decreasing A/D Line is bearish because more stocks are closing the day with losses. Falling values of the A/D line can be used to confirm the likelihood of the downward trend continuing.
2. Divergence-warning toolBecause the A/D Line reflects the action of the general market, technicians watch any divergences closely. Comparing the behavior of the A/D line to market will portray a much weaker or stronger market than can be gleaned by just looking at the surface price action.
Whenever you spot a divergence between price and breadth, trust breadth especially when the divergence is bearish.
As I said, A/D line movement in the same direction as the market confirms the market movement and indicates the movement will continue. As long as the NYSE Index and its A/D Line are moving in the same direction the trend will continue but if the NYSE Index makes a new high, which is not confirmed with a new high of the A/D Line as well, you should be cautious with your bullish views. This negative divergence is sign that the new high was driven by smaller number of stocks than before. It usually tell us that the markets are losing their breadth signaling potential reversals, weak price moves, or may be getting ready to change direction. Conversely, if the NYSE Index makes a new low and the A/D Line doesn't, then caution is warranted with your bearish views.
Remember that divergence can and usually last for more than a day or a week. It can last for very long periods of time. A/D line divergence is not a timing tool but it often indicates that the market's direction is "suspect" and that the current primary market trend is losing steam to the upside or the downside.
Example:
A historical look at the NYSE A/D line tell us that since 2002, it has been powering higher rising always to new high. The rise reflected the stock market’s strong performance and the fact that many issues that trade on the NYSE have been moving higher rather than lower. There have been a few instances when market breadth was poor and the A/D line dropped. However, during the last bull market, those few instances proved to be short-lived. During June-July 2007 (well ahead of market top), something different happened. The AD line peaked and started falling since then.
Check out the chart above to see what happened during that period. You can see $NYA (NYSE Composite Index) made a higher high on both July and October 2007, an acknowledged bullish sign. However, the A/D Line didn’t confirm the index ascent by failing to make a newer high in both instances. That should warranted investors to the fact that the market as a whole was not behind the move higher and should be wary of the advance.
Since October 2007 the A/D Line confirmed the trend in price of the $NYA. The $NYA made lower highs and lower lows and likewise, the A/D line made lower highs and lower lows.
To give you an example of a bullish divergence, look at the recent move in July 2009. $NYA made a lower low, an acknowledged bearish sign. However, the A/D Line did not confirm the index descent by not making a newer low. That should send a signal that market breadth and strength is stronger than the prices would tell us. And always whenever you spot a divergence between price and breadth, trust breadth especially when the divergence is bearish.
Another important indicator that is derived from the A/D data is the Advance/Decline Issues Ratio: $ADRN
Daily Advance/Decline Issues Ratio - $NYADV:$NYDEC - Enlarge
This ratio is derived from dividing (not subtracting) the number of stocks that are currently trading higher (advancing) by the number of stocks that are presently trading lower (declining).
Together with the A/D line, the A/D ratio can be an added confirmation to your analysis to measure the true overall market strength. An increasing A/D ratio with a large positive value indicates a strong market momentum, while decreasing ratio represents a weak market momentum.
Unlike the AD line; the AD ratio can’t be negative. The AD issues ratio is applied as follows:
- Values higher than 1 show that more issues are presently advancing than declining;
- Values between 0 and 1 indicate that more issues are currently declining in price.
The advantage of using A/D Ratio:
1. It remains constant. It has an absolute value that does not vary in function of the number of components being traded on the NYSE.
2. It allows comparisons among different indexes or stock exchanges. For example, comparing the AD ratios of the DJIA and the NYSE is much easier than evaluating the AD lines for the NYSE and the DJIA.
3. It can be used as an Overbought/Oversold Indicator:
The (OB/OS) Indicator is simply a smoothed AD ratio. Smoothing the ratio with a moving average can eliminate daily fluctuations of the A/D Ratio so it can be used as an overbought/oversold indicator. The smoothing is done by taking the 10 or 15-day exponential moving average EMA of the A/D ratio, which makes it fluctuate within a narrower range with heavier weighting given to recent data.
Historically, an extreme average ratio can signal the incoming of a market turn. The higher the value, the more “overbought” the market and the more likely a correction will occur. Likewise, low readings mean an “oversold” market and suggest a technical rally within reach.
Markets, however that appear to be extremely overbought or oversold may stay that way for more than anyone can expect. It is prudent to collect data from number of indicators and wait for the prices to confirm your analysis that a change is due.
4. Like the A/D line divergence principle outlined above, same can be applied to the A/D Ratio as well. For example, higher prices achieved with lower AD ratio means fewer stocks are participating in the new move than the previous one, which is a sign of weakness.
What else to watch?
1. Examining peak and trough A/D line trendline:
The most effective way to do this is to draw trendlines on both the underlying (NYSE) chart and the A/D line chart (green dotted line on the chart above). A break in the A/D line trendline will provide a confirmation of the message given off by the underlying price chart.
2. Violation of the moving averages lines:As you can see from the chart above, the 50 and 200 Daily moving averages are plotted over the AD line. First, the AD line dropped below the 200DMA in November 2007 for the first decisive break of the long-term bullish trendline since the start of 2003 bull market.
Second, The 50DMA crossed below the 200DMA (known as the death cross) during the same month for the first time as well affirming a bearish signal for the market. These were sufficient warnings that market breadth was starting to deteriorate in a serious way late 2007 before the serious damage in the major indexes became obvious.
3. The horsemen and the infantry:Another way to use the AD Line is to look for a divergence between the DJIA (or a similar index like S&P 100) and the NYSE A/D Line. Looking at this parameter allows us to reduce the impact of the large cap stocks, which influence market indexes the most, and instead examine price trends of a diverse range of stocks through a large market like the NYSE. It measures market sentiment and tell us the fraction of the overall market that is participating in the market's up or down move.
Often, an end to a bull market can be forecast when the A/D Line begins to roll over while the DJIA is still trying to make new highs. If history is an indicator, when a divergence develops between the DJIA and the A/D Line, the DJIA has corrected and gone the direction of the A/D Line. A military analogy is often used when discussing the relationship between the A/D Line and the DJIA. The analogy is that trouble looms when the horsemen lead (DJIA is making new highs) and the infantry refuse to follow (A/D Line fails to make new highs).
4. The weekly A/D line:Typically, daily AD Line is used to watch for short to intermediate trends. A weekly AD Line is considered more useful for trend comparisons that span several years. Now and then, check it as well.
As of today and from the chart above we can see that:
1. AD line long-term downturn trend (green line) reversed to the upside.
2. AD line is confirming the overall market strength and bullishness.
3. AD line trend is rising steadily with no bearish divergence.
4. AD line made a golden cross (50 over 200DMA), a bullish indicator.
5. AD line still holding 20DMA, short term bullish indicator.
6. The horsemen as well as the infantry are advancing together.
As a sign of concern:
1. The A/D ratio is declining as you can see from the daily A/D ratio chart above. It's a sign of waning strength and should not be overlooked. Though the weekly A/D ratio is still in uptrend and holding support.
2. While the A/D line overcame its downtrend and flipped it to the upside, the price in the Composite yet to follow. It's not a bearish sign because it takes time for the underlying index to follow the lead of the AD line. That said, it will be a strong bullish sign for the index to follow the A/D line sooner than later.
Until next article and as usual, I wish you as much as you wish for yourselves and even more.
Please rate this article at the top of the page. Thanks!
GoodVibe
MR. Lucky
Footnotes:
*The A/D volume line: I will touch on that in a separate article but for now know that the principles discussed above can be applied not only to the actual number of advancing and declining issues, but also to their respective volume (“advancing volume” and “declining volume”). By applying the above indicators to volume data, as opposed to simply to the number of stocks moving up or down, we can get a better feel for the TRUE prevailing market sentiment and we can uncover those areas where the biggest trading activity is taking place and truly on which side. Stay tuned!
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