DEFINITION of Breadth of Market Theory

The breadth of market theory is a technical analysis methodology that predicts the strength of the market according to the number of stocks that advance or decline in a particular trading day.

The breadth of market theory is often also called the breadth of market indicator.

BREAKING DOWN Breadth of Market Theory

The breadth of market indicator is used to gauge the number of stocks advancing and declining for the day. If the breadth indicator is strong, this theory predicts that the market will be rising and vice versa. For example, if a market is comprised of 150 stocks and 95 stocks experience price gains while 55 stocks either experience no change or decline in price, according to the breadth of market theory, the market is currently considered strong.

While imprecise as a forecasting tool, breadth of market theory does offer an indication of market momentum. At times markets can exhibit trending patterns, be it from a strong economic climate, fundamentals, or a favorable business cycle. Savvy investors can take advantage of this trends if they can recognize inflection points early.

Two popular market breadth methods include the Advance/Decline ratio or the Advance/Decline line. The advance/decline ratio (ADR) compares the number of stocks that closed higher against the number of stocks that closed lower than their previous day's closing prices. To calculate the advance/decline ratio, the number of advancing shares are divided by the number of declining shares. The advance/decline ratio can be calculated for various time periods, such as one day, one week or one month.

The advance/decline line (A/D) as a technical indicator plots changes in the value of the advance/decline index over a specific period of time. Each point on the chart is calculated by taking the difference between the number of advancing/declining issues and adding the result to the previous period's value, as shown by the following formula:

A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Previous Period's A/D Line Value