During every trading day, there are some stocks that advance and some that decline. Advancing stocks mean stocks that open lower and close at higher prices. They end up being bullish at the end of the day. And the stocks that close below their opening prices are declining stocks.
A stock index shows the pulse of the stock market by showing a percentage of selected advancing and declining stocks by giving different weights to different stocks. Hence a stock index has a close relationship with the advancing and declining stocks participating in the day’s trades. The ADL shows a reflection of total advancing and declining stock by calculating the difference in numbers.
What is the Advance Decline (A/D) Line ?
Advance Decline Line (ADL) is a technical indicator that plots the difference between the advancing and declining stock of an index on a daily basis. This gives us a true reflection of the market sentiment for the specified day.
The advance decline line is a single line that reflects the market breadth. It is a market breadth indicator. The indicator is based on Net Advances. Net advances exceed declines exceed advances.
What Does the Advance/Decline Line Indicate?
The advance decline line is a clear indicator of the sentiment of traders in the stock market. During a bullish trend, we will see that the advance decline line is moving up along with the price trending up. It means more and more stocks are participating in the bull run. The trader sees that the market is conducive to trade participation.
Similar things happen when the ADL comes down during a bear trend. When the A/D line goes down making lower lows, it means that more and more stocks are in the selling mode and participating in the bear run.
A trader picks up an overall market sentiment from the advance decline line. When a trader finds divergence, the trader gets the alert signal and waits for price reversal.
Calculation for the Advance Decline Line
The calculation of the ADL is performed as per the formula shown below.
We calculate the advance decline line as per the formula above.
- First, subtract the number of stocks that closed below their opening prices from the number of stocks that closed above their opening prices on a day. The resulting value gives the value of net advances.
- If the value is being calculated for the first time, the net advance value will be the first value that will be used for the ADL indicator.
- Then, on the second day, we add the net advance figure of the previous day with the net advance figure of the second day. after closing data is available. If the net advance is negative, meaning more stocks declined than advanced, the figure will be negative and the net decline number will be subtracted instead of being added.
- Steps one and three will be repeated daily after each EOD data is available for calculations.
Example of the Advance Decline Line
Shown below is an example of a number of advancing stocks and declining stocks of each day for five-day consecutive trading days. Supposing there is a total 100 number of stocks in a market. On the first day, 75 stocks advanced and 25 stocks declined. Hence the net advance for the first day is 50 (75-25). In the same way on the second day is -20, the third day is +12, the fourth -10 and on fifth is +30. We can now put these figures on a chart and find the ADL.
Hence, we will have an ad line that starts in positive territory. The initial reading is +50. Then it changes every day hovering around the zero line and having positive and negative values. This shows the market breadth.
Thus, the ADL indicator continues to form with every input from end-of-day data. The advance decline indicator may or may not agree with the stock index movement.
Interpreting the Advance Decline Line
The advance decline line is used to identify the market trend of a group of stocks or a stock index. This indicator helps us to know the overall market sentiment.
Traders find different meanings of the indicator at different phases of the price action of the index. In the following section, we will get to know how this happens.
Advance Decline Line and Stock Index Trending Upwards
There are instances when both the stock index and the advance decline line move in agreement with each other.
In the diagram below, we can see the index has given a 10% profit or ROI (return on investment) within a specified period of time. Within that same period, the advance decline line moved from the negative territory to 100. A trader uses this opportunity to ride the bull wave when the index and advance decline line goes into a positive zone and go up together.
Advance Decline Line and Stock Index Trending Downwards
This is another scenario. In this case, the advance decline indicator shows agreement with the price movement and goes down in a downtrend. Here the ADL goes into the negative zone and comes down making new lows as well as the price. In this case, the number of declining stocks is more than the number of advancing stocks and their difference is also increasing. More and more stocks are taking participation in the downtrend. It is an ideal scenario for traders to ride the bear wave.
Advance Decline Line Trending Upwards and Stock Index Trending Downwards
Here we can see that though the advance decline line is going upwards, the market movement is in disagreement with the ad line. The stock index is going down and is bearish. This is an ideal example of divergence.
Why does this divergence occur? We know that the index chose a few selected stocks and adds different weights to them. As a result, the index doesn’t show the entire breadth of the market and traders’ sentiment as a whole. Here, in this case, the downward movement of the index is driven by a smaller number of stocks and doesn’t tell the complete story. The ad line shows that more and more stocks are advancing and participating in the bull run. Therefore, when the overall market sentiment is positive, the index is bound to reverse and go up sooner or later. This is an ideal example of bullish divergence. In bullish divergence, a downward index movement reverses and starts a new bull run.
Advance Decline Line Trending Downwards and Stock Index Trending Upwards
This is just the opposite condition of the previous instance. The index is going up but the ad line is coming down. They are also in disagreement with each other. Here the market sentiment is negative but the index is going up driven by a smaller number of bullish stocks. In such a scenario, the index ultimately stops the bull run, reverses and comes down to follow the ad line direction. This is an ideal case of bearish divergence. This is a bearish divergence because the index bull run reverses and starts a new bearish trend.
Difference between the Advance Decline Line and Arms Index (TRIN)
The advance decline indicator and the ARMS Index (TRIN) are very similar types of indicators. Both of them show the market depth. But the ad line is effective in a longer time frame because it takes the daily closing data. The ARMS Index is more effective in shorter time frames. TRIN compares the number of advancing stocks to the ratio of advancing volumes. Therefore, traders get similar but different information from these two.
Limitations of using the Advance Decline line
As with all other indicators, this indicator also has some inherent limitations. The ad line gives equal weight to all stocks. But the big companies carry more weight on the index. Therefore, it is best to use it on the mid-cap or small-cap index.
Also, there are times when some stocks get delisted, or the authority blocks them from trading. But their previous data has already been used in ad line calculations. Therefore, when they stop trading, their previous input remains and affects the ad line movement. Thus, the ad line cannot give very accurate signals all the time.
Conclusion
The advance decline indicator or the ad line, being a breadth indicator reflects the market participation. A large number of advancing (or declining) stocks participating in the trending market reflects the strength of the trend. When a fewer number of stocks leads a trend, the trend is supposed to discontinue and the direction reverses. This is a divergence signal. Divergence helps the chartist to plan for a potential reversal. The advance decline indicator puts equal weight on each stock. Therefore, it is best to use it with the mid-cap or small-cap index.
