The advance-decline (AD) line is a breadth indicator that reflects the number of advancing stocks less those declining to give an indication as the participation by the all securities in the movement of a broader index. The line is positive and moves higher when the number of advances exceeds those in decline and vice versa. When compared with the index the AD line should confirm similar movements in the same direction, with failure to do so forming either bullish or bearish momentum divergence, highlighting the risk of a reversal.
The calculation is very simple and performed by most charting software:
AD Line = Previous value + net advances today
The value of the AD will vary depending on the starting data for the calculation however what is important is that the shape of the AD line confirms the price movements of the index.
If a new high in the stock market is accompanied by a new high of the A/D line, it shows that the rally has broad support and is likely to continue. Broadly based rallies and declines have greater staying power. If the stock market reaches a new peak, but the A/D line reaches a lower peak than during the previous rally, it shows that fewer stocks are participating (narrowing), and the rally may be near its end. This narrowing suggests that the underlying strength is not driving by a broad rally, but by perhaps a few big name stocks with large market capitalisation and therefore at risk of a reversal.
The first chart below shows the ASX200 index along with the AD line for the index constituents, as you can see as the index moves to new highs and lows so does the AD line, confirming the movement of the index. When a rally is confirmed by a broad rally in the number of advancing stocks we can say that the rally strength is strong and therefore likely to continue.
The second chart below shows what happens when the indicator and the index diverge, in this case the index has moved to a new high in May 2013 while the AL line has not. This has formed bearish momentum divergence suggesting that the recent gains are becoming exhausted which is then followed by a sharp decline over the next two months.
It is important to understand the limitations of this indicator, for instance when a stock is delisted or removed from the index it no longer contributes to the calculation of the AD line from that point forward however its negative effect on the AD line prior to that date remains. Overall this is a useful indicator which reflects when a rally is broad based (showing strength) or narrowing (weakness) and can be useful to identify divergence as potential reversal points.
