Advance/Decline Quotes

 Bookmark this

Most traders know that volume data can be used to asses the prevailing market sentiment and that that the advance/decline volume ratio is an excellent indicator for "overbought/oversold" market conditions. But why study volume? Why is it that the market frequently reverses course after one (or several) large volume surges

Let us revisit the definition of "volume":

Volume is the number of shares, traded during a given period, for a security or an entire index or exchange. Volume is also called "trading volume".

Volume data simply shows how many shares were transferred from one group of investors to another - sometimes this data is available broken down by market price, so one can study how much trading activity took place at specific price intervals.

Volume simply shows what happened in the past, it does not directly indicate whether the demand for stock (by willing buyers) outweighs the supply (offered by willing sellers). However, the proper analysis of an index's past volume action allows analysts to anticipate its likely future trends.

Let us analyze Chart 1 below. This is an example of a trend lasting up to several months, which we define as a "mid-term trend". Mid-term moves are principally dictated by the sentiment of mid-term players. Long-term players are usually not too concerned about mid-term fluctuations, as long as they don't upset a prevailing long-term trend. Long-term players are thus likely to wait out mid-term fluctuations before making buy or sell decisions. Similarly, the same principle can applied to short-term traders, who concern themselves primarily with short-term market moves rather than mid- and long-term timeframes.

Chart 1. S&P 500 60-day intraday (one bar = 1 hour)
Advance/Decline Volume Ratio with a 2-Day Moving Average

Between points "A" and "B", the S&P 500 index moved up steadily. This tells us that during this time, buying pressure generally exceeded selling pressure. At point "B", however, you can see that the advance/decline volume ratio peaked at a level of 9.11 (note that a 2-day moving average was used). We can infer from this that following the index's steady ascent (which started in early May), a large number of high-priced shares were being transferred from one group of investors to another between June 7 and June 9 (the two-day average peaking for the indicator on those days). Point "B" is a critical point, because it marks the area where we can say the market is now in danger of becoming "overbought" on a mid-term timeframe. Leading up to point B, willing buyers were the dominant force, but from point B on, the urge of sellers to divest themselves of (some of) their shares has started to grow (after all, there has been quite a run-up). Willing sellers thus risk overpowering eager (new) buyers (which up to this point have kept buying at constantly higher prices). The telltale sign was the big volume surge, which indicated a significant change in sentiment taking place (particularly of the sellers). It is difficult to say what exactly prompted this change of sentiment: did sellers decide to take profits following a long rally? Or was it because on June 7, crude oil prices reached $40 a barrel and the chief investment strategist of a financial company said that crude might reach $42? Or was it because someone announced on the news on June 7 that "Some earnings are coming in below expectations", or all or none of the above? We simply do not know; however, we can say with certainty that whatever force prompted the sellers to suddenly become active was strong enough to stop the upward drive of the index. At first very subtly, the balance of supply and demand started to shift to the sellers. As you can see, the index did not reverse course immediately (it took almost another month for it to turn); in fact, it actually kept moving up, albeit at a much slower pace. During this time, there were still some willing buyers, who had sufficient cash on hand to keep bidding up the price. But leading up to the reversal point (point "C"), the buyers' disposable cash started to dwindle, and each day, further high-priced shares exchanged hands from one group of investors to another. Even previous buyers, having depleted their cash reserves, now probably started to think about selling. In addition, consider those investors who bought in at point "B"; at point "C", they had already been holding a position for a month, and for 80% of the time, it was a losing position. It is thus no wonder that at least some of these traders (mid-term players) started to realize they had bought at the wrong time and probably started thinking about taking a loss.

In our example above, we are studying market action in a mid-term timeframe. In this context, we can say that point "B" marks the critical point from where on the market is in danger of becoming "overbought". We call the time between points "B" and "C" a "distribution phase". Using the example above, we define and characterize a distribution phase as:

• A period of trading usually initiated by a volume surge that is sufficient to stop and reverse an ongoing trend within the near future. This volume surge is indicative of a pronounced change in market sentiment and marks the critical point from where on the market is in danger of becoming "overbought";
• The duration of a distribution phase is extended enough to allow a sufficient number of high-priced shares (in our example, following a prolonged up-trend) to change hands from one group of mid-term traders to another. While our particular example uses a mid-term timeframe, the same principle applies to any other timeframe. This transfer of shares brings the market to the point where it becomes "overbought" in the mid-term;
• The distribution phase is also prolonged enough to allow market sentiment changes to take place, which (in our example above) slowly but surely shift the supply / demand balance from the buy side to the sell side. A sentiment shift takes place for the mid-term players involved: some are glad they sold, while they were in a profit zone, others who recently bought in are starting to realize that their timing was off and are now confronted with mounting losses.

Please Note: In the chart above, the values for the May 19 and June 7 peaks in the advance/decline ratio appear to be almost identical; however, the reading on May 19 was only 6.55, whereas the value on June 7 peaked at 9.11 (i.e., almost 40% higher). The visual distortion in the chart is caused by the use of a logarithmic scale.

The advance/decline volume ratio can be used to determine the point at which an up-trend starts to lose momentum, as a large number of high-priced shares are switching hands ("distribution"). Conversely, following a down-trend, the advance/decline volume ratio can also pinpoint the time when a large number of low-priced shares are being transferred from one group of investors to another ("accumulation"), indicating a weakening of the downward momentum and a possible reversal in the near future. When traders and technical analysts study such charts, they can prepare for a change in the current market sentiment (and as a result, anticipate a trend reversal). Depending on the value of the AD volume ratio, you can make assumptions about how long and how strong a coming a trend reversal might be (i.e., will it be a short-lived correction or lead to a mid- or long-term change in trend).

Next: Advance/Decline Issues

A. v. S.
V. K.

Copyright 2004 - 2010 Highlight Investments Group. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

Free 30-Day Trial (No credit card information will be collected.)
 

We provide our members with: Volume Indicators plotted on Real-Time Intraday Charts. Selling & Buying Volume Indicators plotted on Real-Time intraday Charts. Advance Decline Indicators plotted on Real-Time intraday Charts. Trend  predictions updated daily in our Market Commentary. Buy & Sell Signals for QQQQ, SPDRs and DIA   * Your one-time one Month FREE trial ends on the 30th calendar day after you enroll.

Start using our Professional Charts
and Make Money with our System!

Sign up for a 30-Day Free Trial Now!
(credit card not required)