This Simple Indicator Can Be Used to Spot Trend Reversals
Market breadth indicators are based on the number of stocks going up or down. The Advance-Decline (A/D) Line is the simplest way to measure breadth.
Every day, the major exchanges report the number of stocks that closed higher (advancing issues or AI) and lower (declining issues or DI). 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 means that the number of advancing issues is greater than the number of declining issues. This indicates the majority of stocks are moving higher.
Negative breadth is when the number of declining issues is greater than the number of advancing issues. This indicates the majority of stocks are moving lower.
How Traders Use Advance-Decline (A/D) Line
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 2007, the market indexes pushed to new highs while breadth was falling. This is shown in the chart of the NYSE Composite below.
Following breadth will lead to a number of false signals, a problem that is common with any other indicator. For example, the recovery in the A/D Line 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 was most likely due to individual investors trying to find bargains in the aftermath of the dot-com crash.
This indicator often moves higher after a sharp price decline. This is because traders usually 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.
Why A/D Line Matters To Traders
Traders are always looking to gauge the market. One of the best ways to do this is by analyzing breadth.
Breadth is a very important tool to confirm price trends. If a market is rallying with wide breadth, then it’s considered healthy. But if breadth reverses, then it could be time to sell.
The A/D Line is the simplest breadth indicator. It simply looks at the number of stocks advancing compared to the number of stocks declining.
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.
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