By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com
Looking at the flow of money in and out of a security is one of the best ways to determine the likely directions of a security. At the most basic level, the price of a security is determined by the supply and demand for that security, which can both be illustrated by the money flow of the security.
One of the most commonly used indicators to determine the money flow of a security is the accumulation/distribution line (A/D line). It is similar to on-balance volume indicator but instead of only considering the closing price of the security for the period it also takes into account the trading range for the period. This is thought to give a more accurate picture of money flow than of balance volume.
The first thing that is calculated is the close location value (CLV), which is a reflection of the closing price of the period relative to the range of the trading. The CLV ranges between +1 and -1, where a value of +1 means the close is equal to the high and the value of -1 means the close was the low. When the CLV is equal to zero, it means that price closed exactly halfway between the high and the low for the day.
The CLV value is then multiplied by the volume and similar to on-balance volume is added to a running total. By multiplying volume by the CLV, the calculation effectively weighs the money flowing in and out of the security.
The CLV is calculated as:
For example, if the high for the day was $59, the low $50, and the close was $55 the CLV would be calculated as follows:
If the volume for the trading day was 10 million shares, the amount added to the accumulation/distribution line would be +1,110,000. As can be seen this value is much different from the +10 million that would be added in the on-balance value measure.
Uses of the accumulation/distribution line
The A/D line measures the trend in the amount of buying or selling pressure in a security. When the line is trending up is a signal of increasing buying pressure as the stock is closing above the halfway point of the range. If the line is trending downward it is a signal of increasing selling pressure in the security.
This line can be used to determine the strength of a trend along with identifying divergence to signal a trend change. The strength of a price trend can be identified by looking at the direction of the trend in the A/D line. It is important that the price trend and the A/D line be trending in the same direction for the price trend to be considered strong.
The A/D line can also be used to identify situations of divergence, which can signal a shift in the price trend. This occurs when the price trend and the A/D line are moving in opposite directions.A bullish signal is formed when there is positive divergence, which means that the A/D line is trending upward while the price is trending downward. A rising A/D line signals that buying pressure is increasing, which should eventually lead to price increases. It is difficult to imagine that a price can continue to fall while buying pressure is clearly increasing.
A bearish signal is formed when there is negative divergence, which occurs when the A/D line is trending downward while the price is trending upward. A falling A/D line is a sign of selling pressure, which as it increases makes it difficult for the upward price trend to continue.
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