Breadth Indicators
How Healthy is the Trend?
April 20, 2020
How do we Measure the Health of the Trend?
In addition to measuring the attitudes of market players (sentiment), the technical analyst needs to look at the internal
strength of a market. By looking at data specific to each market, the analyst determines whether the internal strength of the
espective market is improving or deteriorating.
On any given day, a stock price can do one of three things: close higher, close lower, or remain unchanged from the
previous day's close. If a closing price is above its previous close, it is considered to be advancing, or an advance.
Similarly, a stock that closes below the previous day's close is a declining stock, or a decline. A stock that closes at the
exact price it closed the day before is called unchanged.
Advance/decline data is called the
eadth of the stock market. The indicators we focus on in this section measure the
internal strength of the market by considering whether stocks are gaining or losing in price.
The Concept of Divergence
The most important technical concept for confirmation of a trend is
called a divergence. As long as an indicator— especially one that
measures the rate of change of price or other data (called
momentum)— co
esponds with the price trend, the indicator is
said to “confirm” the price trend. When an indicator or oscillator
fails to confirm the trend, it is called a negative divergence or
positive divergence, depending on whether peaks or bottoms,
espectively, fail to confirm price peaks or bottoms. A divergence is
an early warning of a potential trend change. It means the analyst
must watch the price data more closely than when the indicators
and oscillators are confirming new highs and lows. Divergence
analysis is used between almost all indicators and prices; a
divergence can occur more than one time before a price reversal.
What is an Oscillator?
Oscillators are indicators that are designed to determine
whether a market is “ove
ought” or “oversold.”
Usually, an oscillator will be plotted at the bottom of a
graph, below the price action.
As the name implies, an oscillator is an indicator that
goes back and forth within a range. Ove
ought and
oversold conditions (the market extremes) are indicated
y the extreme values of the oscillator. In other words, as
the market moves from ove
ought, to fairly valued, to
oversold, the value of the oscillator moves from one
extreme to the other. Different oscillator indicators have
different ranges in which they vary. Often, the oscillator
will be scaled to range from 100 to —100 or 1 to —1 (called
ounded), but it can also be open ended (unbounded).
Important Breadth Indicators
The Breadth Line or Advance-Decline Line
The
eadth line, also known as the advance-decline line, is one of
the most common and best ways of measuring
eadth and internal
market strength. This line is the cumulative sum of advances minus
declines.
Ordinarily, the plot of the
eadth line should roughly replicate the
stock market averages. In other words, when the stock market
averages are rising, the
eadth line should rise. This indicates that
a market rally is associated with the majority of the stocks rising.
Important Breadth Indicators
Advance-Decline Line to Its 32-Week Simple Moving
Average
Analysts have developed several variations of using the
advance-decline line. One method is to compare it with its own
moving average to give buy and sell signals for the market and, thus,
create an oscillator. Ned Davis Research, Inc. used a ratio of the
NYSE advance-decline line to its 32-week simple moving average. It
found that from 1965 to 2010 when the ratio rises above 1.04, the
per annum increase in stock prices as measured by the NYSE
Composite Index was 19.3%, and when it declined below 0.97, the
stock market declined 11.2% per annum.
Important Breadth Indicators
McClellan Oscillato
In 1969, Sherman and Marian McClellan developed the
McClellan Oscillator. This oscillator is the difference
etween two exponential moving averages of
advances minus declines. The two averages are an
exponential equivalent to a 19-day and 39-day moving
average. Extremes in the oscillator occur at the +100 or +150
and —100 or —150 levels, indicating respectively an
ove
ought and oversold stock market.
The rationale for this oscillator is that in intermediate-term
ove
ought and oversold periods, shorter moving averages
tend to rise faster than longer-term moving averages.
However, if the investor waits for the moving average to
everse direction, a large portion of the price move has
already taken place. A ratio of two moving averages is much
more sensitive than a single average and will often reverse
direction coincident to, or before, the reverse in prices,
especially when the ratio has reached an extreme.
Important Breadth Indicators
McClellan Summation Index
The McClellan summation index is a measure of the area under the curve of the McClellan Oscillator. It is calculated by
accumulating the daily McClellan Oscillator figures into a cumulative index.
Important Breadth Indicators
Advance-Decline Ratio
This ratio is determined by dividing the number of
advances by the number of declines. The ratio or its
components are then smoothed over some specific
time to dampen the oscillations. Using daily
eadth
statistics between 1947 and 2000, Ned Davis
Research, Inc., found 30 buy signals were generated
when the ratio of ten-day advances to ten-day
declines exceeded 1.91. These signals averaged a
17.9% return over the following year. In only one of
the 30 instances did the signal fail, and the loss then
was only 5.6%.
Important Breadth Indicators
Breadth Thrust
A thrust is when a deviation from the norm is
sufficiently large to be noticeable and when that
deviation signals either the end of an old trend or the
eginning of a new trend.
Martin Zweig devised the most common
eadth
thrust indicator, calculating a ten-day simple moving
average of advances divided by the sum of advances
and declines.
The indicator signals the start of a potential new bull
market when it moves from a level of below 40%
(indicating an oversold market) to a level above
61.5% within any 10-day period. This is a rarely
occu
ing sentiment, which ca
ies tremendous
import with market watchers.
Up and Down Volume Indicators
Breadth indicators assess market strength by counting the number of stocks that traded up or down on a particular day. An
alternative way to gauge market internals is to measure the up volume and down volume. Up volume is the volume traded in all
advancing stocks, and down volume is the total volume traded in declining stocks. Up and down volume figures are reported in most
financial media.
Considering the volume, rather than only the number of stocks traded, places more emphasis on stocks that are
actively trading.
With the
eadth indicators, a stock that moves up on very light trading is given equal importance to one that moves up on heavy
trading. By adding volume measures, the lightly traded stock does not have as much influence on the indicator as a heavily traded
stock. The one caveat with using volume is that occasionally an enormous trade in a low-priced stock will upset the daily figures
Up and Down Volume Indicators
The Arms Index
The Arms Index measures the relative volume in
advancing stocks versus declining stocks. When a large
amount of volume in declining stock occurs, the market is
likely at or close to a bottom. Conversely, heavy volume in
advancing stocks is usually healthy for the market.
The numerator is the ratio of the advances to declines,
and the denominator is the ratio of the up volume to the
down volume. If the absolute number of advancing shares
increases on low volume, the ratio will rise. This higher
level of the Arms Index would indicate that, although the
number of shares advancing is rising, the market is not
strong because there is relatively low volume to support
the price increases. This ratio, thus, travels inversely to
market prices (unless plotted inversely), tending to peak
at market bottoms and bottom at market peaks. This
inverse relationship can initially be confusing to the chart
eader.
Up and Down Volume Indicators
Volume Thrust
Using up volume and down volume only and forming
an oscillator that is a moving average of the ratio of
one to another produces an oscillator that has an
excellent history of producing profitable thrusts,
especially on the Nasdaq. Shown is a chart (Figure
14.10) that represents the specific method devised by
Ned Davis Research, Inc. It is a ratio of the
10-day up volume to the 10-day down volume
with thresholds at 1.48, above which is a
thrust buy, and 1.00, below which is a sell.
The performance is measured by the
prospects for the market when the ratio is in
one of three ranges. Above 1.48, the Nasdaq
advanced for an annualized gain of 38.9%;
etween 1.48 and 1.00, the annualized gain
declined to a positive 12.9%; and below 1.00,
it produced a loss of 7.4% annualized.
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Up and Down Volume Indicators
Ninety Percent Downside Days (NPDD)
Paul F. Desmond, in his Charles H. Dow Award paper (Desmond, 2002), presents a reliable method for identifying major stock market
ottoms that uses daily upside and downside volume as well as daily points gained and points lost. A 90% downside day occurs when, on a
particular day, the percentage of downside volume exceeds the total of upside and downside volume by 90% and the percentage of
downside points exceeds the total of gained points and lost points by 90%. A 90% upside day occurs when both the upside volume and the
points gained are 90% of their respective totals. What he found was that
■ An NPDD in isolation is only a warning of potential danger ahead, suggesting, “Investors are in a mood to panic” (Desmond, 2002,
p. 38).
■ An NPDD occu
ing right after a new market high or on a surprise negative news announcement is usually associated with a
short-term co
ection.
■ When two or more NPDDs occur, so do additional NPDDs, often 30 trading days or more apart.
■ Big volume rally periods of two