The Advance Decline Line is used primarily to confirm price movement and detect divergences. The calculation of the Advance Decline Line is quite simple:
New York Stock Exchange (NYSE) Advancing Issues – NYSE Declining Issues
The calculated number is then added to the previous day's Advance Decline Line. To illustrate, say that todays advancing issues ($ADV or $NYADV) is 1,692 stocks. That is 1,692 stocks closed the day with an increase in their share price. The declining issues ($DECL or $NYDEC) is 1,311. At the NYSE, 1,311 closed the day with a decrease in their share price.
1,692 – 1,311 = +381
For the day, 381 more stocks closed the day higher than closed the day lower. This is a bullish sign. To continue the example, yesterday's Advance Decline Line totaled 45,874. Today's reading of +381 would be added to the total of yesterday. This would result in an updated total of 46,255.
Whether the total is positive or negative is irrelavent; what is relavent is the direction or the trend of the Advance Decline Line. An increasing Advance Decline Line is bullish because more stocks at the NYSE are closing the day with gains; whereas a decreasing Advance Decline Line is bearish because more stocks are closing the day with losses.
The Advance Decline Line is a powerful confirmation tool and divergence warning tool. The chart of the mini-Dow future contract of the Dow Jones Industrial Average or Dow 30 represents these confirmation and divergence signals:
High #1 to High #2
The mini-Dow future contract made a higher high at High #2; however, the Advance Decline Line failed to make a newer high, in fact it made a lower low. At High #2, less stocks were participating in the rally; thus, there was less strength behind the rally in the Dow Jones Industrial Average. This failure of the Advance Decline Line signaled a strong bearish divergence.
High #2 to High #3
This is an example of the Advance Decline Line confirming the trend in price of the mini-Dow future. The mini-Dow future made lower highs and likewise, the Advance Decline Ratio made lower highs.
Low #1 to Low #2
Yet another bearish divergence occured from Low #1 to Low #2. The mini-Dow futures contract made a higher low, an acknowledged bullish sign. However, the Advance Decline Line did not confirm the mini-Dow future's ascent. In fact, during the entire rally of the mini-Dow from Low #1 to Low #2, the Advance Decline Line was making lower lows. This bearish divergence signaled that stock traders and index futures traders should be wary of the recent increases; the market as a whole is not behind the recent move higher.
In conclusion, the Advance Decline Line is a very effective tool to confirm price action in stocks and stock indexes as well as signaling potential reversals or weak price moves. Another similar indicator is the Arms Index [TRIN], (see: Arms Index).
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