Trading the trends is one of the most followed stock trading strategies. Long traders buy stocks at the start of an uptrend and sell them when the trend diminishes. Similarly short traders take short positions at the start of a downtrend and close there positions when the trend ends. Sounds like a very good strategy! But the problem is “how can we know a trend is starting or ending” and “is the trend has enough strength to bring prices to new highs or lows”. A simple but effective tool to solve this problem is the “Advance – Decline Index or A-D Index”
Advance – Decline index measures the strength of a market movement. It is one of the most widely used trend analyzing tools by short-term and long-term traders trading all types of financial instruments – stocks, bonds, currencies, futures, etc. AD index is defined as the ‘difference between total number of bullish or advancing stocks and total number of bearish or declining stocks’. The value can be a positive or negative integer. But with this single value analyzing trend strengths is difficult. So traders plot this value on a chart as an ‘Advanced-Decline line’, connecting points of each time periods. One point of the line can be derived from a simple formula.
A-D point = A-D value of the period + A-D value of previous period.
The period can be of any time frame; day traders can use short time periods like 15 or 30 minutes or 1 hour, other traders can use daily, weekly or monthly periods. Most trading systems today have AD index as a standard indicator.
Interpreting advance-decline indicator is easy.
- Market up and AD down – Strong uptrend.
- Market up and AD up – Weak uptrend.
- Market down and AD down – Strong downtrend.
- Market down and AD up – Weak downtrend.
The major advantages of AD indicator are its simplicity and scalability. It can indicate trend weakening and possible trend changes. But AD index cannot be used as a main tool to predict trend reversals. Traders should use other indicators like volume indicators, Fibonacci tools together with AD index to predict trend changes.