When traders first start out, they typically follow the standard approach to trend analysis…
They rely on basic indicators such as moving averages and oscillators to determine if the stock market is trending, how strong the current trend is and whether or not it’s approaching overbought or oversold levels.
While these basic technical indicators provide important data about past market behavior, there are better indicators that can give you a more broad picture of what’s in store for the market in the short term…
Let’s start with learning how to use the AD Line…
How to Use the AD Line
The advance/decline line is a market breadth indicator that’s based on the net advancing stocks, which is the difference between the number of advancing stocks and declining stocks on a daily basis.
The net advance is a positive number when there are more stocks advancing then declining, and negative when there’s a larger number of declining stocks compared to advancing stocks.
The AD line rises when the net advances become positive and falls when the net advances become negative. The final daily advance and decline numbers are reported by the NYSE on a daily basis after the closing bell.
How to Use the AD Line for Market Analysis
One way professional traders use the AD line is by comparing it to an index to determine if the AD Line is confirming its price action.
There’s usually divergence between the AD line and the index, which is a good indication that a short-term correction is approaching.
Notice how the NYSE is beginning to decline while the AD line continues to move upward at a slight angle.
The stock market continues moving higher after the bullish divergence occurs.
Now here’s an example of bearish divergence between the NYSE and the AD line. You can see how the NYSE is moving lower while the AD line begins making higher lows.
The market turns bullish a short time later and continues moving higher as well.
Examining prior divergence levels between the stock market and the AD line suggests that most divergence occurs within a short-to-medium-term time period.
Backtesting results suggest that most periods last between one and six weeks.
Why the AD Line Is Effective in Market Trend Analysis
The AD line represents the entire market equally as opposed to the index, which is capitalization weighted, meaning the large-cap stocks influence the index a lot more than smaller stocks.
Because the index is so easily influenced by a few large-cap stocks, learning how to use the AD line creates a good check-and-balance system to see how the market is behaving as a whole
Avoid Using the Nasdaq AD Line
While the NYSE AD line is a great indicator for trend analysis, the Nasdaq AD line should be avoided for several reasons.
First, the Nasdaq has a wide range of stocks including those that have been recently listed and are super speculative.
The issue is that these stocks prices can rise and fall quickly based on pure speculation.
Companies are also oftentimes removed from the Nasdaq due to not meeting capitalization requirements…
So because there are more newer companies in the Nasdaq, their influence on the market may be short-lived and less meaningful than stocks that trade on the NYSE.
You should learn how to use the AD line on the NYSE because it’s more stable and reliable on a long-term basis.
Things to Keep in Mind
The AD line is a market breadth indicator that measures broad-based market participation… Which means if a market rally is broad across many different sectors, the AD line will move sharply higher.
If the rally is caused by a few large-cap stocks, the AD line will move slightly higher.
Conversely, if the markets drop as a result from several hundred stocks, the AD line will drop. And if the decline is limited to a few large-cap stocks, the decline will be small.
Similarly, the AD line does a great job of measuring divergence.
If a bullish divergence occurs between the AD line and the index, the market should continue moving higher.
If a bearish divergence occurs between the market and the AD line, the market will begin to lose steam and likely experience a correction in the coming days.
For more on this topic, please go to: How to Pick Winning Stocks With Simple Market Analysis Tools and Critical Stock Market Analysis Tools You Need to Know.
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All the best,
Roger Scott
Senior Strategist, WealthPress
