When traders first start out they typically follow the standard approach to stock market trend analysis.
Most traders 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 the market is approaching overbought and oversold levels as well.
While these basic technical indicators provide important data about past market behavior, there are some indicators that can give you a broad picture of what the short term future has in store for stock market prices.
The NYSE Advance Decline Line – The Advance Decline Line also known as AD Line is a market breadth indicator that is based on the Net Advancing stocks, this is the number of advancing stocks less the number of declining stocks.
The Net Advances is a positive number when there are more stocks advancing then declining and negative when there is a larger number of declining stocks compared to advancing stocks.
The AD line rises when Net Advances becomes positive and falls when Net Advances becomes negative. The final daily NYSE advance and decline numbers are reported by the NYSE on a daily basis after the closing bell.
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How To Use AD Line for Market Analysis
One way professional traders utilize the AD Line is to compare it to the stock market index and determine if the AD Line is confirming the price action of the index.
Often times, there is 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 is still continuing to move upwards at a slight angle. The stock market continues moving higher after the bullish divergence occurs.
The Stock Market Began Moving Lower While The AD Line Remained Bullish
Here is 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 stock 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.
Back testing results suggest that most periods last between 1 and 6 weeks.
Bearish Divergence Generally Occurs After Strong Down Trend
Why Is the AD Line Effective in Stock Market Trend Analysis
The AD line represents the entire stock market equally as opposed to the index which is capitalized weighted, meaning the large cap stocks influence the index substantially more than the smaller capitalized stocks.
Because the index is so easily influenced by a few large cap stocks the AD Line creates a good check and balance system to see how the stock market is behaving a a whole.
Avoid Using the Nasdaq AD Line
While the NYSE AD Line is a great indicator for stock market trend analysis, the NASDAQ AD line should be avoided for several reasons.
First, the Nasdaq exchange has a wide range of stocks including those that have been recently listed and are extremely speculative.
These issues are can move very quickly from high prices to low prices based on pure speculation.
Companies are also removed from the Nasdaq index often times due to not meeting capitalization requirements.
Because there are substantially more newer companies on the Nasdaq exchange their influence on the stock market may be short lived and less meaningful than stocks that traded on the NYSE exchange.
I highly recommend only using the NYSE AD Line in your daily stock market analysis because it is very 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. If the stock market rally is broad across many different sectors the AD Line will move sharply higher.
If the rally is caused by a few large capitalized stocks the AD Line will move slightly higher.
Conversely, if a stock market drop results from several hundred stocks the AD Line will drop strongly 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 between the stock market.
If a bullish divergence occurs between the AD Line and the Index the stock market will most likely continue moving higher.
If a bearish divergence occurs between the stock market and the AD Line the stock market will most like begin losing steam and will experience a correction in the coming days.