Trend-Spotting With The Accumulation/Distribution Line

by John Devcic,
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Filed Under: Active Trading, Forex

The accumulation/distribution line was created by Marc Chaikin to determine the flow of money into or out of a security. It should not be confused with the advance/decline line. While their initials might be the same, these are entirely different indicators, and their uses are different as well. Whereas the advance/decline line can provide insight into market movements, the accumulation/distribution line is of use to traders looking to measure buy/sell pressure on a security or confirm the strength of a trend. Read on to learn how to use accumulation/distribution to analyze a security. (Read more about Marc Chaikin in Discovering Keltner Channels And The Chaikin Oscillator.)

Close Location Value
The first step in creating the accumulation/distribution (A/D) line is finding the close location value (CLV), which looks at the location of the close and compares it to the range for a given period (one day, week or month). The CLV will have a value from +1 to -1:

A value of zero would mean that the price closed halfway between the high and low of the range.
A value of +1 means the close is equal to the high of the range.
A value of -1 means the close is equal to the low of the range.

The CLV can be calculated as follows:

CLV = ([(C-L) - (H - C)] / (H - L))

Where:

C = the closing price
H = the high of the price range
L = the low of the price range

The CLV is then multiplied by the corresponding period's volume, and the total will form the A/D line. (For a look at the CLV's precursor, the on-balance volume, read Introduction To On-Balance Volume.)

Benefits and Drawbacks of Using the A/D Line
In some instances, using the A/D line can give traders a clear advantage:

Monitor General Money Flow - The A/D line can be used as a gauge for the general flow of money. If the A/D line is moving higher, this signals that there is buying pressure that is starting to prevail. On the flip side, if the A/D line is moving downward, this signals that increased selling pressure is beginning to gain a foothold.
Confirmation - You can also use the A/D line to confirm the strength, and possibly the longevity, of a current move.

There are also a few drawbacks to keep in mind when analyzing a security using the A/D line:

Trading Gaps - The A/D line does not take trading gaps into consideration, so these gaps, when they occur, may not be factored into the A/D line at all. Therefore, if a stock's price has gapped upward but closes around the midpoint, that gap will be ignored because the A/D line is formulated using closing prices. (To learn about profiting from trading gaps, read Playing The Gap.)
Minor Changes - Sometimes it can be difficult to detect minor changes in volume flows. The rate of change in a downtrend could be slowing, but this would be difficult (if not impossible) to detect until the A/D line turned upward. (To learn how to monitor trends in volume, read Volume Rate Of Change.)

Bullish and Bearish Signals
The A/D line creates both bullish and bearish signals. These signals rely on divergence and confirmation.

Bullish Signals
Bullish signals occur when the price of a security is moving down or is in a downtrend, but A/D line is trending upward (see Figure 1). This divergence signals increased buying pressure, which can indicate weakening seller strength. It is usually followed by a change in the trend of the security from downward to upward.

Figure 1: A chart of Goldman Sachs (NYSE:GS) clearly shows that the current A/D line has moved positively while the stock continues to be in a downward trend.

Source: StockCharts.com

Bearish Signals
A bearish signal is formed when the A/D line is trending downward, but the price of the security is in an uptrend (see Figure 2). Selling pressure is beginning to increase, which usually signals a future downtrend in the price.

Figure 2: A chart of AT&T (NYSE:ATT) shows the A/D line moving downward while the stock price continues its uptrend. While the divergence is early, what you are looking for is a separation between the price and the A/D line.

Source: StockCharts.com

Spotting a Divergence
In order to spot bearish and bullish signals, you need to have a trend in the underlying security. Once this has been established, you can begin to look for a divergence from that trend. When spotting these divergences, either bullish or bearish, it is best to allow a week or two for the signals to develop. When it comes to bearish patterns, you want to keep an eye out for signals that are flat or do not have a sharp divergence – these can also signal that no future change is probable. (For more information, see Divergence: The Trade Most Profitable.)

Other Indicators
There are other indicators that can be used along with the A/D line.

Money Flow Index
The money flow index (MFI) is a volume-weighted momentum indicator. This indicator compares positive money flow to negative money flow and creates an indicator that can then be compared to the price of the security to identify the current strength or weakness of a trend. It is calculated using a 14-day period.

The MFI has a scale from 0-100. This scale is a range:

A security that is close to 100 usually signals an overbought position. In reality, an overbought position can be signaled by an MFI value around 80.
A security that is near zero will signal an oversold position. A value of around 20 usually qualifies a position as oversold. (For further reading, see The Basics Of Money Flow.)

Relative Strength Index
Another indicator that can be used with the A/D line is the relative strength index (RSI), a momentum oscillator. The RSI is calculated by taking the magnitude of a stock's recent gains and comparing it to the magnitude of a stock's recent losses. The RSI has a number range from 0-100. Like the MFI, it is used primarily to highlight overbought and oversold conditions. The RSI is best used as a complement to another technical tool to analyze a security. (To learn more, read Ride The RSI Roller coaster.)

Combining Indicators and Oscillators
While using the A/D line by itself is indeed feasible, it is even more advantageous to add either the MFI, the RSI, or both. Since the MFI and RSI both give a range, they can be used to spotlight extreme conditions that the A/D line was not designed to spotlight.

While the RSI and MFI both attempt to highlight overbought or oversold positions, they go about it in different ways:

The MFI measures the flow of money into a security, whether that money is positive or negative.
The RSI compares the magnitude of a stock's recent gains to its recent losses.

Neither of these technical tools overlaps, so they can indeed be used in conjunction with the A/D line. (For more information, see our Exploring Oscillators And Indicators tutorial.)

The A/D Line in Action
The following is a three-month chart of Kellogg Co. (NYSE:K). This is a perfect example of the A/D line showing us that the strength of the uptrend is indeed sound. As the trend continues upward, the A/D shows that this uptrend has longevity. Even after a minor drop in the stock price starting August 11, 2008, the A/D line continued to signal strength. The stock had then begun to turn around again.

Figure 3

Source: StockCharts.com

The next example is Pfizer Inc. (NYSE:PFE). This is a two-month chart, and the A/D line confirmed both the uptrend and the downtrend. At the right of the chart, the stock looks like it is beginning to follow the lead that the A/D line signaled early on in August 2008.

Figure 4

Source: StockCharts.com

The following is a two-month chart of Apple Inc. (Nasdaq:AAPL). The A/D line and stock price have gone hand in hand. Apple has been on a downtrend, and the A/D line has been confirming existing selling pressure on the stock, forcing it to go down. The A/D line is confirming a downtrend at the latest date on the chart.

Figure 5

Source: StockCharts.com

Conclusion
The accumulation/distribution line is an effective tool for spotlighting buying and selling pressure on a security. It is also a fantastic way to confirm an existing trend. Using the A/D line alone is one way to analyze a security, but it can also be used with either the MFI or the RSI to refine the analysis. Since both the RSI and MFI work well with the A/D line, using them together can help you get a better sense of overbought or oversold situations. In the end, the A/D line is an effective tool in any trader's arsenal.

by John Devcic, (Contact Author | Biography)

John Devcic is a freelance writer, market historian and private speculator. After investing in a mutual fund right out of high school and losing his initial investment of $350, Devcic began to believe he could do better with his money then the so-called experts could. Over the years a healthy and sometimes unhealthy obsession with how the markets work and how they worked in the past has made Devcic a true market historian. He reminds himself at all times that the market - while ever-changing – always seems to repeat itself.

Filed Under: Active Trading, Forex

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