The percent above moving average (PAMA) is a breadth indicator which measures the strength of an underlying index similar to the Advance-Decline line. This indicator can be used to determine whether an index is short-term over or under bought, bullish or bearish cross below the 50% level as well as divergences to identify potential reversals.
The calculation is very simple, we simply add the number of stocks trading above a specific moving average divided by the total number of stocks in the index. Using the ASX200 as an example for stocks above their 200 day moving average, if 50 stocks are above their 200 day moving average (50/200) = 25% or 0.25.
By measuring the degree of participation in a rally or decline of the underlying index we can determine whether the move is broad based, therefore strong and likely to continue or narrow and therefore weak and likely to reverse. Breadth is strong and the index has a bullish bias when the majority of stocks in the underlying index are above their specific moving average, while the inverse is also true that breadth is weak and the index has a bearish bias when the majority of stocks are below their specific moving average.
The first chart below shows the ASX200 index which has rallied strongly since early February 2016 while the PAMA indicator using the 200 day moving average has remained above the 50% level since then. We can then say that this this is a broad based rally that shows strength and therefore more likely to continue than reverse. Using the 50% level for the trend bias typically works better with longer-term moving averages such as the 100 or 200 day moving average as there longer periods tend to smooth out the noise generated by the use of shorter periods.
Similar to our RSI and Stochastic oscillators that generate over and under bought signals (click here for more information of RSI’s and here for Stochastic’s) we can use the PAMA indicator to identify potential buying and selling opportunities. We can use traditional levels of above 80% or 0.8 to signal the price is overbought while readings below 20% or 0.2 signal the price is oversold.
The second chart below shows the same ASX200 index and we can see that our PAMA indicator (200 day moving average) has a reading greater than 0.8 or 80% signalling that the price has become overbought and has an increased risk of a pause or pullback in the short-term, as we saw in late May 2016. Given we try to always trade in the same direction as the dominant trend, when the longer-term trend is up short-term oversold readings are preferred to enter long positions while conversely when the longer-term trend is down short-term overbought readings are preferred for selling positions.
Finally we can also identify bullish or bearish divergences between the peaks and troughs of the underlying index with the peaks and troughs of the PAMA indicator. When peaks of troughs of the underlying index are not confirmed by higher peaks or lower troughs on the PAMA indicator it is a signal that the underlying strength of the trend is fading and susceptible to a reversal.
The third chart below shows the ASX200 and PAMA indicator (200 day moving average) which has formed clear bullish momentum divergence between August 2015 and February 2016. Our PAMA indicator has a reading of 0.26 at the August 2015 low of the index at 4,928. Over the next six months the index continues lower to reach a new low in February 2016 of 4,706 however the PAMA indicator has only moved as low as 0.37. The fact the move lower by the index is not confirmed by a new low on the PAMA indicator suggests that the declines are becoming exhausted, which is confirmed when the ASX200 rallies strongly from February to August 2016.
To conclude the PAMA indicator is useful as a breadth indicator to determine the level of participation of a move in the underlying index. It can be used to identify the bias of a trend, over or under bought levels as well as bearish or bullish momentum divergence for potential reversals however as with all indicators this should be used in conjunction with further analysis to confirm or disprove signals.
