Tuesday, March 23, 2010

Why you should forget about the Sensex and Nifty and look at the Advance-Decline (A-D) line instead

The Advance-Decline line is very simple to construct and the starting point can begin from any day. Why should one use it? The Sensex comprises only 30 stocks, and the Nifty comprises 50 stocks. Mostly these are large-cap shares. They are supposed to represent the overall stock market.

But the stock market trades a few thousand shares every day - mostly mid-cap and small-cap stocks which are preferred by small investors. So looking at an index of 30 or 50 large cap stocks may not provide the complete picture.

The BSE 500 index comprises 500 shares, and may be more representative of daily market trading action. But it is not a popular index. Technical analysis experts on business channels and the pink papers mostly rely on Sensex or Nifty levels in trying to gauge the state of the markets.

The Advance-Decline line is a proper market breadth indicator. Which means it gives the real picture of what happens every day about all the stocks traded on that particular day. Not the 30 or 50 or 500 that make up different indices.

The calculation is so simple that a school-going child can figure it out:-

A-D line = (No. of advancing stocks - No. of Declining stocks) + previous day's A-D line value

Let us say we want to start from today, when the total number of shares that advanced in value in today's trading was 1323 and the total number of shares that declined in value was 1600. So the value of the A-D line for today is (1323 - 1600 =) -277.

To avoid dealing with negative numbers, we can start with an arbitrary large number like 10000. In which case, today's A-D line value will be (10000 - 277 =) 9723. Wednesday is a trading holiday, so Thursday's value of the A-D line will be 9723 + (No. of advancing shares - No. of declining shares).

The A-D line can also be expressed as a ratio:-

A-D ratio = {(No. of advancing stocks - No. of declining stocks)/Total no. of stocks traded} + previous day's A-D ratio

Now that we know all the arithmetic behind the A-D line, how do we make use of it? Very simple. During bull markets, the A-D line is supposed to rise. During bear markets it is supposed to fall. But what we are really interested in is any divergences.

If the Sensex or Nifty rises and the A-D line falls (like today), then it indicates poor breadth and a possible change of trend. Now one day's divergence can't be taken too seriously. But if the index continues to rise when the A-D line is falling, or vice versa, a trend reversal is the likely outcome.

We also look at divergences like the index making a new low while the A-D line makes a higher low, or the index making a new high while the A-D line makes a lower high.

As with other technical indicators, the A-D line is not fool-proof. It tends to work better at giving warnings about impending market tops (usually peaking before the index) rather than about market bottoms.

Unfortunately, none of the chart software I have access to include the advance-decline line indicator. So I'm not able to provide a practical example. However, the Advance-Decline (A-D) line indicator is so easy to construct, that a simple graph paper and pencil is all you need to draw it.

(If any reader has software that supports the A-D line, I'll be grateful if you can email me a Sensex with A-D line graph for the past 3 years. I'll post it with due acknowledgement.)


Sanjeev Bhatia said...

Dear Shubhanker Ji,
Your post couldnot have come at a better time. I was just exploring this AD number (or ratio) as a possible means of predciting trend reversal or atleast be cautious. There is a very useful link which I would like to share with all the readers of this wonderful blog. The link (http://www.icharts.in/breadth-charts.html) gives updated view of AD line versus Nifty and has been an eye opener. Just see how nifty is making new highs while AD line is dropping like it has no bottom. Is it indicative of an impending correction? Maybe its the financial year end NAV saga that is driving the indices while the broader market languishes. Your comments please...

Subhankar said...

Really appreciate the A-D line link, Sanjeev.

I've been using icharts.in site for a while but missed the breadth charts some how.

Looks pretty ominous, doesn't it? Plus the fact that the index is at the Jan '10 top means that we are poised for a decent correction sooner than later.