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Wednesday, January 23, 2013 - 06:00
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Wednesday, January 23, 2013 - 06:00
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Wednesday, January 23, 2013 - 06:00

Advance-Decline Line: Simple Breadth Indicator Can Be Used to Spot Trend Reversals

Wednesday, January 23, 2013 6:00 AM

Market breadth indicators are based on the number of stocks going up or down and the Advance-Decline (A-D) Line is the simplest way to measure breadth. Every day, the number of stocks that closed higher (advancing issues or AI) and lower (declining issues or DI) is reported by the exchanges.

The A-D Line can also be found for any group of stocks, like the Dow Jones Industrial Average, by tracking the direction of the close for the stocks in that group. The A-D Line is found by subtracting the number of declining issues from the number of advancing issues (AI - DI).

Positive breadth, meaning that the number of advancing issues is greater than the number of declining issues, indicates the majority of stocks are moving higher, while negative breadth is seen when most stocks are falling. Negative breadth means that there are more declining issues than advancing issues.

How Traders Use It
In a strong price trend, the A-D Line will move in the same direction as the price. If the majority of stocks are advancing while prices are moving higher, as measured by a major index like the S&P 500, then breadth is confirming price. In a downtrend, prices should fall while the A-D Line declines. Divergences between price and breadth are usually signs of trend reversal.

For example, in early 2000, the market indexes pushed to new highs while breadth was falling. This is shown in the chart of the S&P 500 below.

Following breadth will lead to a number of false signals, a problem that is common with any other indicator.

As an example of a signal that didn't work, the recovery in the A-D Line that is seen in the chart of the S&P 500 late in 2000 did not lead to an upward trend in the indexes. The gain in the A-D Line that was seen then was most likely due to individual investors trying to find bargains.

This indicator often moves higher after a sharp price decline as traders buy hoping they have found a bottom. Because of that, the A/D Line is more useful for analyzing the action in an uptrend rather than a downtrend.

Action to Take --> Traders wanting to analyze breadth quickly will use this indicator. Breadth is a very important tool to confirm the price trend and the A-D Line is the simplest breadth indicator.

Divergences tend to be very important at significant market tops. Because many individual investors buy more stocks when markets are falling, the A-D Line is less useful in declines.

This article originally appeared on ProfitableTrading.com:
Advance-Decline Line: Simple Breadth Indicator Can Be Used to Spot Trend Reversals

[Note: My colleague Amber Hestla of ProfitableTrading.com has put the finishing touches on a report that answers ten commonly-asked questions about boosting income with options. If you'd like learn more about generating income using options, simply click here and tell us where to send the report.]

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.