Thirty stocks make up the Dow Jones Industrial Average. If the Dow moves up 20 points, there's no way to tell from that number if the increase is the result of only one stock going way up or many stocks each going up a small amount. The advance/decline data for the Dow can answer this question. If five stocks advance and 10 stocks decline (while 15 remain unchanged), then only a few stocks are responsible for carrying the market higher. Therefore, the rally is not broad-based.
In this section, we examine the many ways market technicians use advance/decline data to interpret the breadth of the market. The advance/decline numbers for the NYSE and the Nasdaq are reported each day, and some of the related charts are the most popular internal indicators.
The advance/decline line is the most popular of all internal indicators by far. It is a very simple measure of how many stocks are taking part in a rally or sell-off. This is the very meaning of market breadth, which answers the question, "how broad is the rally?" The formula for the advance/decline line looks like this:
|A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Yesterday\'s A/D Line Value|
The most popular data used for the A/D line is from the NYSE or Nasdaq markets. It is cumulative and normally plots a line similar to the price chart of the given index. The A/D line can be used alone or together with the price chart to look for divergences. A divergence suggests that a move in the price chart is unsupported by the broad market, and it should, therefore, be taken as a warning of an impending turning point in the index or market.
A traditional technical indicator, such as a moving average or a stochastic oscillator, can be applied to the chart or used to smooth the signals it gives.
A variation on the A/D line is the A/D spread. Just as its name implies, the A/D spread charts the difference between the number of advancing stocks and declining stocks in a given market on a given day. Unlike the A/D line, the spread is not a cumulative chart, so each day is calculated separately. The formula for the A/D spread looks like this:
|A/D Spread = # of Advancing Stocks - # of Declining Stocks|
The chart of the A/D spread is an oscillator that revolves around a zero line. The A/D spread is interpreted much like any oscillator with overbought and oversold levels near the extremes of the chart. When the A/D spread crosses above its zero line, this means more stocks are advancing than declining, and vice versa.
This oscillator is extremely fast, so a moving average is usually applied to slow the chart's movements and signals. The technician can fine tune the number of days set for the moving average to the market data.
Another variation on the A/D line is the advance/decline ratio, which divides the advancers by the decliners. Here is the formula:
|A/D Ratio = # of Advancing Stocks / # of Declining Stocks|
This formula creates values that cannot be less than zero because it is a fraction (or ratio). A value of 3 means that three times as many stocks advanced as declined. Any value less than 1 means more stocks declined than advanced. Because of the nature of fractions, the chart is more legible using a logarithmic scale. Like the A/D spread, this chart moves quickly, so it's usually smoothed with a moving average.
Absolute Breadth Index
The absolute breadth index is a measure of internal volatility. It calculates the absolute value of the difference between the number of advancing and declining stocks, making it a slight variation on the A/D spread. The formula for ABI looks like this:
|ABI = | (# of Advancing Stocks - # of Declining Stocks) ||
Because the ABI is an absolute, its value will always be positive. The chart is a representation of the volatility in the spread between advancers and decliners. The ABI can be smoothed using a moving average to facilitate drawing longer-term trend lines. A fast-paced, choppy chart of the ABI can indicate a choppy, range-bound market.
Breadth thrust is an internal indicator that is somewhat more complicated and harder to find. It is a ratio of moving averages that creates an excellent judge of market momentum. The formula looks like this:
|Thrust = x-Day Moving Average of Advancing Stocks / x-Day Moving Average of (Advancing Stocks + Declining Stocks)|
Since this formula creates a ratio whose denominator is a sum of both advancers and decliners, the value cannot be greater than 1 or less than zero. The breadth thrust indicator, therefore, creates a percentage value that moves just like a traditional oscillator from 1 to 100 (or .01 to 1.00).
Breadth thrust can be read just like a stochastic or RSI, where overbought and oversold levels are at the extremes. Divergence with the underlying price chart points to weakening momentum. The number of days to set for the moving averages should be determined by the time-period being evaluated.
Arms Index (TRIN)
Developed by Richard Arms, TRIN is a double-ratio that divides the A/D ratio by the A/D volume ratio. The formula is somewhat long but, fortunately, the TRIN charts for the NYSE and Nasdaq are some of the easier internal indicators to find on the internet. For those who are curious, here's the formula:
|TRIN = (# of Advancing Stocks / # of Declining Stocks) / (Volume of Advancing Stocks / Volume of Declining Stocks)|
For reasons that should now be obvious, the value of TRIN cannot be less than zero. The Arms Index is read somewhat counter intuitively. A value of less than 1 means advancing stocks are getting more than their share of volume, which is bullish for the market. When the value of TRIN is more than 1, declining shares are taking an outsized amount of volume, which is bearish for the market.
TRIN is usually smoothed using a moving average, which should be tuned to the time-period being evaluated. Trend lines drawn from the moving average reveal the direction of market momentum. (Remember that the value for TRIN moves down as advancing volume goes up).
Searching for an even more refined internal indicator, Sherman McClellan designed his own oscillator. Though the calculations for McClellan's Oscillator are far too complicated to compute by hand, they help demonstrate how the indicator works, so here they are:
|McClellan Oscillator = [ 19-Day Exp. Moving Average of (# of Advancing Stocks - # of Declining Stocks) ] / [ 39-Day Exp. Moving Average of (# of Advancing Stocks - # of Declining Stocks)]|
This formula creates a ratio comparing the 19-day and 39-day EMA of the A/D spread. The chart is an oscillator that ranges from +100 to –100 with overbought and oversold levels usually found at +70 and –70 respectively. The McClellan Oscillator can be read just like any other oscillator and is usually not smoothed, but it can be charted with a moving average as an indicator line.
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