What Is a Diffusion Index?
Used in technical analysis, a diffusion index measures the percentage of stocks that have advanced in price or are showing a positive momentum over a defined period. A diffusion index also refers to the measure of the breadth of a move in any of the Conference Boards Business Cycle Indicators (BCI), showing how many of an indicator's components are moving together with the overall indicator index.
The Basics of the Diffusion Index
The diffusion index – also known as the advance/decline diffusion index – is one of the many different forecasting tools used by technical analysts to increase the probability of picking winning stocks. The index can also signal when the markets are bullish or bearish.
The diffusion index can also help an economist or trader interpret any of the composite indexes of the BCI more accurately. The diffusion index breaks down the indexes and analyzes the components separately, exhibiting the degree to which they are moving in agreement with the dominant direction of the index.
Calculating the Diffusion or Advance/Decline Index
In order to calculate the index, you'll need some basic values, including the advances and declines for a certain period of time, as well as the value of the previous diffusion index, which you will use as a baseline. Calculating the index is done by using a simple formula:
- Index = (Advances - Declines) + Previous Index Value
Once you calculate the index, you can determine its magnitude. If it's close to the previous index value, you can assume that it's steady or unchanged. Any number that is significantly higher will indicate an expansion or a strong rise. Conversely, if it is much lower than the baseline or previous index value, you can assume a contraction or significant drop in the current index.
Using the Diffusion Index
Most traders use the diffusion or advance/decline index to come up with opportunities. They can then use other forms of technical analysis to generate trading signals. The index is typically plotted on a chart, which is known as the advance/decline line, or AD line.
The AD line is usually plotted over the top or below the security's price and is commonly used with a graph depicting advances and declines below it. Traders can use these indicators to see whether a trend is gaining or losing momentum.
How to Interpret the Index
Once the diffusion index is calculated, traders can use them to determine market sentiment. If the line moves upwards or shows a high, it indicates that participation in the stock is bullish. But if there is a decline, that participation becomes bearish. Traders can then estimate an entry or exit point by studying the trends on these charts.