MARKET BREADTH ANALYSIS
Breadth analysis is one of the most valuable aspects in technical analysis. It introduces a new dimension to analysis, where it reveals the true strength or weakness of the targeted market. Such dimension is not attainable from the standard price and volume chart.
Breadth Analysis can be applied to any sector in the market or to a specific industry group as long as there is a way to determine their constituents and the components.
In the last few decades analysts have managed to develop some very sophisticated technical indicators based on market breadth. Some of which form a part of this article.
Market breadth indicators are sometimes referred to as broad market indicators, since they do not refer to individual stocks.
Did you know?
In 1901, Charles H.Dow commented in his June 23,1900, editorial in the wall street journal about the number of advancing and declining issues-”Of these 174 stocks, 107 advanced, 47 declined, and 20 stood still.”
This gives us an idea that Market breadth analysis had been paid attention to long before the studies around such analysis came out.
MARKET BREADTH INDICATORS
ADVANCE DECLINE LINE
The advance-decline line is perhaps the most commonly known and used market breadth indicator of all time. Probably because of its simple calculation and application. It is a long- term indicator that shows the general trend of a certain market.
AD Line = (Advancing Issue – Declining Issues)+AD line previous value
Its a trend-following indicator that provides valuable information every day the market trades. There are many variations of the advance-decline line, such as A/D ratio or smoothed versions of the advance-decline line itself.
CALCULATION OF A/D LINE(EXAMPLE)
Day 1, Advancing stocks= 100, Declining stocks= 20, A/D Line= (100 – 20) + 0 = 80
Day 2, Advancing stocks= 70, Declining stocks= 50, A/D Line= (70 – 50) + 80 = 100
Day 3, Advancing stocks= 55, Declining stocks= 65, A/D Line= (55 – 65) + 100 = 90
Day 4, Advancing stocks= 110, Declining stocks=10 , A/D Line= (110 – 10) + 90 = 190
USE OF A/D LINE
Now that you understand how its calculated. Lets understand one of the important uses of it.
But before that lets be on the same page that when market moves up along with the A/D line its a sign of strength but if the A/D line does not agree with the market. It could be a sign that market is losing steam.
We all know the great saying, “Trouble looms when the generals lead but troops refuse to follow.”
Which, takes us to the point that spotting DIVERGENCE with help of A/D line is arguably the most important use of it.
Divergence means a situation where an indicator and price are disagreeing with each other.
- A rising market with a declining A/D line reflects that though the market is making new highs, nonetheless, lesser stocks are following this uptrend every day, indicating that the current uptrend may reverse soon.
- A declining market with a rising A/D line reflects that though the market is declining, the number of stocks that are following that decline is getting lesser every day.
An example of Bearish divergence spotted with help of A/D line(red)
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The McClellan oscillator is a breadth oscillator created by Sherman and Marian McClellan in 1969. The McClellan oscillator uses the daily advancing minus declining stocks by smoothing them with two different exponential moving averages and then taking the difference between them.
CALCULATION OF MCCLELLAN OSCILLATOR
- Calculate the daily difference between advancing stocks and declining stocks.
- Calculate a 19-day exponential moving average of the difference between advancing stocks and declining stocks.
- Calculate a 39-day exponential moving average of the difference between advancing stocks and declining stocks.
- Take the difference between 19-day EMA and 39 days EMA.
When the McClellan crosses zero to the upside it means that the 19-day EMA broke the 39-day EMA to the upside. A violation of zero to the downside coincides with the 19-day EMA breaking the 39-day EMA downwards. Positive values in the oscillator are seen as bullish, while negative values are seen as bearish.
USE OF MCCLELLAN OSCILLATOR
- OVERBOUGHT/OVERSOLD LEVEL: The McClellan oscillator is very useful when it reaches overbought levels and then begins to turn down, or reaches oversold levels and turns up afterward. As we know, it is an unbounded oscillator, so overbought and oversold zones can be detected by visual inspection.(You need to mark the historical resistance at high indicator levels manually and regard the zone as overbought and vice versa for oversold)
- DIVERGENCE: The McClellan oscillator can track divergences with price action. Usually, when the price of the market gauge is still rising and the McClellan declines, it is considered a negative divergence. Positive divergences can occur too.
As you can see the oscillator(lower channel) facing resistance 4 times at a higher level, By visual inspection this can be marked as the overbought level.
NEW HIGH-NEW LOW OSCILLATOR
The new high-new low (NH-NL) oscillator is one of the leading breadth indicators that are used to hint of potential strength or weakness in the market.
Usually, when an uptrend is underway, more stocks reach new highs (new 52-week high). During a downtrend, more stocks reach new lows.
That is exactly what the indicator measures.
CALCULATION OF NH-NL OSCILLATOR
The NH-NL oscillator is calculated by taking the difference between stocks making new 52-week highs and stocks that make new 52-week lows.
Just like other breadth indicators this can be used to spot divergences and OB/OS levels.
More than that this gives important hints when the mainstream indices are in a mood a deceive.
SOME POINTS ABOUT BREADTH ANALYSIS
- Breadth treats each stock the same, regardless of price, number of shares or even volume.
- It is usually a leading type of analysis, which provides valuable information for the purpose of forecasting trend reversals.
- Breadth analysis is flexible enough to allow for several techniques and strategies, which is very essential due to market alternations.
- Being leading has its own limitations for providing signals too early.
- Most of market breadth indicators are better used in the smoothed form rather than the raw form, which some may consider a minor limitation.
- Breadth data seems to be inconsistent among the data providers. In emerging markets it is even hard to acquire breadth data.
I hope you got an idea about how this study of market works. The study of market breadth gives a great edge over others ignoring this aspect of market analysis. We discussed about 3 breadth market indicators in the article to give you an idea about such indicators. I urge the readers to look into more such indicators and include the study of market breadth in their analysis.
Breadth analysis is a very complex job that requires a lot of time and effort. Breadth indicators are leading indicators that will give early signals; such signals must be treated as setup, while the actual signal must be triggered from the price action itself. There are hundreds of breadth indicators; make sure you know few of them that meet your trading objectives and discipline.
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By Animesh Vashisht