How to Detect the Market Reversal by Advance/Decline Line (AD)

According to Wikipedia, the advance/decline line (ADL) is a stock market technical indicator used by speculators to measure the number of individual stocks participating in a market rise or fall.

Often time, the price movement of large stocks could have an unequal effect on the general market indices (such as Dow Jones, NASDAQ, and S&P 500). This phenomenon allows traders to perceive how widely this fluctuation impacts on larger clusters of smaller-cap stocks. The formula to calculate the ADL is:

ADL=Today’s Advances Issues – Today’s Declines Issues + Yesterday’s ADL

 

Advances & Declines

	NYSE	NASDAQ
Advances	1,341 (32%)	937 (36%)
Declines	2,639 (64%)	1,521 (59%)
Unchanged	151 (4%)	131 (5%)
Up Vol*	924 (28%)	731 (44%)
Down Vol*	2,259 (70%)	903 (54%

ADL is one of the most aged indicators based on the Advance and Decline figures. You can obtain the Advances Issues and Declines Issues from Yahoo Finance. The above figure shows the data on 9/28/2013. We collected daily data for our trading log. The ADL for 9/27/2013 is 1011 (2499-1488), thus the ADL for today 9/28/2013 is

ADL=(1341-2639)+1011=-287

As long as you have daily reading for ADL, you can plot chart on it with the indices of the general market over a certain time frame, and search for the correlation between them.  Traders and investors are using this indicator to verify the current market trending, and detect the potential market reversal.

For example, the stock market keeps moving up. However, the ADL does not keep the same pace. It might provide warning signals that indicate the internal weakness of the stock market. To accomplish this, you can examine and compare the ADL slope against the indices. If slopes for these two lines go to the same direction, then the market movement direction is confirmed, otherwise, you have to be well prepared for the potential reversals.

ADL is referred as a breadth indicator. The ADL gauges the scale of participation in a market rise or decline. The relationship between ADL and the underlying index can foretell the market sentiment either bullishness or bearishness. If an ADL advances and reaches a new record high, and the general market index moves up with same pace, then the market shows the bullish sentiment.

On the other hand, if the stock market records a new high, but the ADL does not follow the pace, then the bearish sentiment is detected. The methodology behind this correlation is that degree of stock participation is able to undermine the market strength. Likewise, when the market is moving downward, the market shows strength if the ADL does not reach the new low correspondingly. This might indicate the potential market reversal.

Of course, no any single technical indicator can work perfectly 100% of time. To better detect the market sentiment and potential market reversals, you had better combine ADL with other technical indicators.

Thanks for your visiting and reading.