Stock Market Indicators
posted under
Philosophy of Technical Analysis
by ceecabolos
MEASURING MARKET BREADTH
In the previous chapter, we described the top-down approach that is most commonly employed in stock market analysis. With that approach, you begin your analysis with a study of the health of the overall market. Then you work down to market sectors and industry groups. The final step is the study of individual stocks. Your goal is to pick the best stocks in the best groups in an environment when the stock market is technically healthy. The study of market sectors and individual stocks can be accomplished with the technical tools employed throughout this book—including chart patterns, volume analysis, trendlines, moving averages, oscillators, etc. Those same indicators can also be applied to the major market averages. But there's another class of market indicators widely employed in stock market analysis whose purpose is to determine the health of the overall stock market by measuring market breadth. The data used in their construction are advancing versus declining issues, new highs versus new lows, and up volume versus down volume.
SAMPLE DATA
If you check the Stock Market Data Bank section of The Wall Street Journal (Section C, page 2) each day, you'll find the following data for the previous trading day. The numbers shown are based on an actual day's trading results.
The above figures are derived from New York Stock Exchange (NYSE) data. A similar breakdown is also shown for the NASDAQ and the American Stock Exchange. We'll concentrate on the NYSE in this discussion. It just so happens that on that particular day the Dow Jones Industrial Average had gained 12.20 points. So the market was up as measured by the Dow. However, there were more declining stocks (1,559) than advancing stocks (1,327), suggesting that the broader market didn't fare as well as the Dow. There was also more declining volume than advancing volume. Those two sets of figures suggest that market breadth was actually negative for that particular day—even though the Dow itself closed higher. The other figures present a more mixed picture. The number of stocks hitting new 52 week highs (78) was greater than those hitting new lows (43) suggesting a positive market environment. However, the closing tick (the number of stocks that closed on an uptick versus a downtick) was a neg‑
Stock Market Indicators 435
ative, –135. That meant that 135 more stocks closed on a downtick than an uptick, a short term negative factor. The negative closing tick, however, is offset by a closing Arms (Trin) reading of .96 which is mildly positive. We'll explain why that is later in the chapter. All of these internal market readings have one intended purpose—to give us a more accurate reading on the health of the overall market that isn't always reflected in the movement of the Dow itself.
COMPARING MARKET AVERAGES
Another way to study the breadth of the market is to compare the performance of the stock averages themselves. Using the same day's trading as an example, the following data lists the relative performance of the major stock averages:
Dow Industrials
+12.20
(+.16%)
S&P 500
54—.64
(—.07%)
Nasdaq Composite
—14.47
(—.92%)
Russell 2000
—3.80
(—.89%)
The first thing that is clear is that the Dow Industrials was the only market average to gain on the day. On all the TV news programs that night, investors were told that the market (represented by the Dow) was up for the day. Yet all the other measures were actually down. Notice also that the broader the average (the more stocks included) the worse it did. Compare the percentage changes. The 30 stock Dow gained .16%. The S&P 500 lost .07%. The Nasdaq Composite, which includes more than 5,000 stocks, was the day's worst performer and lost .92%. Almost as bad as the Nasdaq was the Russell 2000 (–.89%), which is a measure of 2000 small cap stocks. The message in this brief comparison is that even though the Dow gained on the day, the overall market lost ground as measured by the more broader based stock averages. We'll revisit the idea of comparing market averages again. But first, let's show the different ways market technicians can analyze the market's breadth numbers.
THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is positive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market averages are trending in the same direction.
THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street Journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is positive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market averages are trending in the same direction. THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street Journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is positive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market averages are trending in the same direction.
AD DIVERGENCE
What does the advance-decline line measure? The advance-decline line tells us whether or not the broader universe of 3500 NYSE stocks is advancing in line with the most widely followed stock averages, which include only the 30 Dow Industrials or the 500 stocks in the S&P 500. To paraphrase a Wall Street maxim: the advance-decline line tells us if the "troops" are keeping up with the "generals." As long as the AD line is advancing with the Dow Industrials, for example, the breadth or health of the market is good. The danger appears when the AD line begins to diverge from the Dow. In other words, when you have a situation where the Dow Industrials are hitting new highs while the broader market (measured by the AD line) isn't following, technicians begin to worry about "bad market breadth" or an AD divergence. Historically, the AD line peaks out well ahead of the market averages, which is why it's watched so closely.
DAILY VERSUS WEEKLY AD LINES
The daily AD line, which we have described herein, is better used for short to intermediate comparisons with the major stock averages. It is less useful for comparisons going back several years. A weekly advance-decline line measures the number of advancing versus declining stocks for the entire week. Those figures are published in Barron's each weekend. A weekly advance-decline line is considered more useful for trend comparisons spanning several years. While a negative divergence in the daily AD line may warn of short to intermediate problems in the market, it's necessary to also show a similar divergence in the weekly AD line to confirm that a more serious problem is developing.
VARIATIONS IN AD LINE
Since the number of stocks traded on the NYSE has grown over the years, some market analysts believe the method of subtract‑
ing the number of declining issues from the number of advancing issues gives greater weight to the more recent data. To combat that problem, many technicians prefer to use an advance/decline ratio which divides the number of advancing issues by the number of declining issues. Some also believe that there's value in including the number of unchanged issues in the calculation. Whichever way the AD line is calculated, its use is always the same—that is, to measure the direction of the broader market and to ensure it's moving in the same direction as the more narrowly constructed, but popular market averages. Advance decline lines can also be constructed for the American Stock Exchange and the Nasdaq Market. Market technicians like to construct overbought/oversold oscillators on the AD lines to help measure short to intermediate term market extremes in the breadth figures themselves. One of the better known examples is the McClellan Oscillator.
McCLELLAN OSCILLATORDeveloped by Sherman McClellan, this oscillator is constructed by taking the difference between two exponential moving averages of the daily NYSE advance-decline figures. The McClellan Oscillator is the difference between the 19 day (10% trend) and the 39 day (5% trend) exponential moving averages of the daily net advance decline figures. The oscillator fluctuates around a zero line with its upper and lower extremes ranging from +100 and –100. A McClellan Oscillator reading above +100 is a signal of an overbought stock market. A reading below –100 is considered an oversold stock market. Crossings above and below the zero line are also interpreted as short to intermediate term buying and selling signals respectively McCLELLAN SUMMATION INDEXThe Summation Index is simply a longer range version of the McClellan Oscillator. The McClellan Summation Index is a cumulative sum of each day's positive or negative readings in the McClellan Oscillator. Whereas the McClellan Oscillator is used for short to intermediate trading purposes, the Summation Index provides a longer range view of market breadth and is used to spot major market turning points. NEW HIGHS VERSUS NEW LOWS
In addition to the number of advancing and declining stocks, the financial press also publishes the number of stocks hitting new 52 week highs or new 52 week lows. Here again, these figures are available on a daily and weekly basis. There are two ways to show these figures. One way is to plot the two lines separately. Since the daily values can sometimes be erratic, moving averages (usually 10 days) are plotted to present a smoother picture of the two lines. (See Figure 18.4.) In a strong market, the number of new highs should be much greater than the number of new lows. When the number of new highs start to decline, or the number of new lows start to expand, a caution signal is given. A negative market signal is activated when the moving average of new lows crosses above.
the moving average of new highs. It can also be shown that whenever the new highs reach an extreme, the market has a topping tendency. Similarly, whenever new lows reach an extreme, the market is near a bottom. Another way to use the new highs versus new lows numbers is to plot the difference between the two lines.
NEW HIGH-NEW LOW INDEXThe advantage of a New High-New Low index is that it can be directly compared to one of the major market averages. In that way, the high-low line can be used just like an advance-decline line. (See Figure 18.5.) The trend of the high-low line can be chart
and it can be used to spot market divergences. A new high in the Dow, for example, that is not matched by a corresponding new high in the high-low line could be a sign of weakness in the broader market. Trendline and moving-average analysis can be applied to the line itself. But its major value is in either confirming or diverging from the major stock trends and giving early warning of potential trend changes in the overall market. Dr. Alexander Elder describes the New High-New Low index as "probably the best leading indicator of the stock market" Trading for a Living, (Wiley).
Elder suggests plotting the indicator as a histogram with a horizontal reference point at its zero line, making divergences easier to spot. He points out that crossings above and below the zero line also reflect bullish and bearish shifts in market psychology.
UPSIDE VERSUS DOWNSIDE VOLUME
This is the third and final piece of data that is utilized to measure the breadth of the market. The New York Stock Exchange also provides the level of volume in both the advancing and declining issues. That data is also available the next day in the financial press. It is then possible to compare the upside volume versus the downside volume to measure which is dominant at any given time. (See Figure 18.6.) The upside volume and downside volume can be shown as two separate lines (just as we did with the new highs and new lows figures) or the difference can be shown as a single line. Either way, the interpretation is always the same. When the upside volume is domi‑ss nant, the market is strong. When downside volume is greater, the market is weak. It's possible to combine the number of advancing and declining issues with advancing and declining volume. That's what Richard Arms did in the creation of the Arms Index.
THE ARMS INDEX
The Arms Index, named after its creator Richard Arms, is a ratio of a ratio. The numerator is the ratio of the number of advancing issues divided by the number of declining issues. The denominator is the advancing volume divided by declining volume. The purpose of the Arms Index is to gauge whether there's more volume in rising or falling stocks. A reading below 1.0 indicates more volume in rising stocks and is positive. A reading above 1.0 reflects more volume in declining issues and is negative. On an intraday basis, a very high Arms Index reading is positive, while a very low reading is negative. The Arms Index, therefore, is a contrary indicator that trends in the opposite direction of the market. It can be used for intraday trading by tracking its direction and for spotting signs of short term market extremes. (See Figure 18.7.)
TRIN VERSUS TICK
The Arms Index (TRIN) can be used in conjunction with the TICK indicator for intraday trading. TICK measures the difference between the number of stocks trading on an uptick versus the number trading on a downtick. The TICK is a minute-by-minute version of the daily advance-decline line and is used for the same purpose. When combining the two during the day, a rising TICK indicator and a falling Arms Index (TRIN) are positive, while a falling TICK indicator and a rising Arms Index (TRIN) are negative. The Arms Index, however, can also be used for longer range analysis.
SMOOTHING THE ARMS INDEX
While the Arms Index is quoted throughout the trading day and has some short term forecasting value, most traders use a 10 day moving average of its values. According to Arms himself, a 10 day average of the Arms Index above 1.20 is considered oversold, while a 10 day Arms value below .70 is overbought, although those numbers may shift depending on the overall trend of the market. Arms expresses a preference for Fibonacci numbers as well. He suggests using a 21 day Arms Index in addition to the 10 day version. He also utilizes 21 day and 55 day moving-average crossovers of the Arms Index to generate good intermediate term
trades. For more in-depth treatment, read The Arms Index (TRIN) by Richard W. Arms, Jr.
OPEN ARMS
In calculating the 10 day Arms Index, each day's closing value is determined using the four inputs and that final value is smoothed with a 10 day moving average. In the "Open" version of the Arms Index, each of the four components in the formula is averaged separately over a period of 10 days. The Open Arms Index is then calculated from those four different averages. Many analysts prefer the Open Arms version to the original version. Different moving average lengths, like 21 and 55 days, can also be applied to the Open Arms version. EQUIVOLUME CHARTINGAlthough Arms is best known for creating the Arms Index, he has also pioneered other ways of combining price and volume analysis. In doing so, he created an entirely new form of charting called Equivolume. In the traditional bar chart, the day's trading range is shown on the price bar with the volume bar plotted at the bottom of the chart. Since technical analysts combine price and volume analysis, they have to look at both parts of the chart at the same time. On the Equivolume chart, each price bar is shown as a rectangle. The height of the rectangle measures the day's trading range. The width of the rectangle is determined by that day's volume. Heavier volume days produce a wider rectangle. Lighter volume days are reflected in a narrower rectangle.As a rule, a bullish price breakout should always be accompanied by a burst of trading activity. On an Equivolume chart, therefore, a bullish price breakout should be accompanied by a noticeably wider rectangle. Equivolume charting combines price and volume analysis into one chart and makes for much easier comparisons between price and volume. In an uptrend, for example, up days should see wider rectangles while down days should see narrower rectangles. Equivolume charting can be applied to market averages as well as individual stocks and can be plotted for both daily and weekly charts. For more information, consult Volume Cycles in the Stock Market by Richard Arms (Dow Jones-Irwin, 1983).
CANDLEPOWER
In Chapter 12, Greg Morris explained candlestick charting. In a 1990 article published in Technical Analysis of Stocks and Commodities magazine entitled "East Meets West: CandlePower Charting," Morris proposed combining candlestick charts with Arms' Equivolume charting method. Morris' version shows the candlestick chart in an Equivolume format. In other words, the width of the candlestick is determined by the volume. The greater the volume, the wider the candlestick. Morris called the combination CandlePower charting. Quoting from the article: ". . . the CandlePower chart offers similar if not better information than Equivolume or candlestick charting and is as visually appealing as either of them." Morris' CandlePower technique is available on Metastock charting software (published by Equis International, 3950 S. 700 East, Suite 100, Salt Lake City, UT 84107 [800] 8823040, www.equis.com). However its name has been changed to Candlevolume.
COMPARING MARKET AVERAGES
At the start of the chapter, we mentioned that another way to gauge market breadth was to compare the different market averages themselves. We're talking here primarily about the Dow Industrials, the S&P 500, the New York Stock Exchange Index, the Nasdaq Composite, and the Russell 2000. Each measures a slightly different portion of the market. The Dow and the S&P 500 capture the trends of a relatively small number of large capitalization stocks. The NYSE Composite Index includes all stocks traded on the New York Stock Exchange, and gives a slightly broader perspective. Breakouts in the Dow Industrials should, as a rule, be confirmed by similar breakouts in both the S&P 500 and the NYSE Composite Index if the breakout is to have staying power.
450 Chapter 18
Most important divergences involve the Nasdaq and the Russell 2000. The Nasdaq Composite has the largest number of stocks (5000). However, since the Nasdaq is a capitalization-weighted index, it is usually dominated by the one hundred largest technology stocks like Intel and Microsoft. Because of that, the Nasdaq is more often a measure of the direction of the technology sector. The Russell 2000 is a truer measure of the smaller stock universe. Both indexes, however, should be trending upward along with the Dow and the S&P 500 if the trend of the market is truly healthy.Relative strength (RS) analysis plays a useful role here. A ratio of the Nasdaq to the S&P 500 tells us whether the technology stocks are leading or lagging. It's usually better for the market if they're leading and the ratio line is rising. comparison of the Russell 2000 and the S&P 500 tells us whether the "troops" are following the "generals." When the small stocks are showing poor relative strength, or are lagging too far behind the large stocks, that's often a warning that market breadth is weakening.CONCLUSION
Another example of comparing two market averages for signs of confirmation or divergence involves the Dow Theory. In Chapter 2, we discussed the importance of the relationship between the Dow Industrials and the Dow Transports. A Dow Theory buy signal is present when both averages hit new highs. When one diverges from the other, a caution signal is given. It can be seen then that the study of market breadth, and the related issues of confirmation and divergence, can take many forms. The general rule to follow is that the greater the number of stock market averages that are trending in the same direction, the greater the chances are for that trend continuing. In addition, be sure to check the advance-decline line, the new highs-new lows line, and the upside-downside volume lines to make sure that they're also trending in the same direction.
In the previous chapter, we described the top-down approach that is most commonly employed in stock market analysis. With that approach, you begin your analysis with a study of the health of the overall market. Then you work down to market sectors and industry groups. The final step is the study of individual stocks. Your goal is to pick the best stocks in the best groups in an environment when the stock market is technically healthy. The study of market sectors and individual stocks can be accomplished with the technical tools employed throughout this book—including chart patterns, volume analysis, trendlines, moving averages, oscillators, etc. Those same indicators can also be applied to the major market averages. But there's another class of market indicators widely employed in stock market analysis whose purpose is to determine the health of the overall stock market by measuring market breadth. The data used in their construction are advancing versus declining issues, new highs versus new lows, and up volume versus down volume.
SAMPLE DATA
If you check the Stock Market Data Bank section of The Wall Street Journal (Section C, page 2) each day, you'll find the following data for the previous trading day. The numbers shown are based on an actual day's trading results.
The above figures are derived from New York Stock Exchange (NYSE) data. A similar breakdown is also shown for the NASDAQ and the American Stock Exchange. We'll concentrate on the NYSE in this discussion. It just so happens that on that particular day the Dow Jones Industrial Average had gained 12.20 points. So the market was up as measured by the Dow. However, there were more declining stocks (1,559) than advancing stocks (1,327), suggesting that the broader market didn't fare as well as the Dow. There was also more declining volume than advancing volume. Those two sets of figures suggest that market breadth was actually negative for that particular day—even though the Dow itself closed higher. The other figures present a more mixed picture. The number of stocks hitting new 52 week highs (78) was greater than those hitting new lows (43) suggesting a positive market environment. However, the closing tick (the number of stocks that closed on an uptick versus a downtick) was a neg‑
Stock Market Indicators 435
ative, –135. That meant that 135 more stocks closed on a downtick than an uptick, a short term negative factor. The negative closing tick, however, is offset by a closing Arms (Trin) reading of .96 which is mildly positive. We'll explain why that is later in the chapter. All of these internal market readings have one intended purpose—to give us a more accurate reading on the health of the overall market that isn't always reflected in the movement of the Dow itself.
COMPARING MARKET AVERAGES
Another way to study the breadth of the market is to compare the performance of the stock averages themselves. Using the same day's trading as an example, the following data lists the relative performance of the major stock averages:
Dow Industrials
+12.20
(+.16%)
S&P 500
54—.64
(—.07%)
Nasdaq Composite
—14.47
(—.92%)
Russell 2000
—3.80
(—.89%)
The first thing that is clear is that the Dow Industrials was the only market average to gain on the day. On all the TV news programs that night, investors were told that the market (represented by the Dow) was up for the day. Yet all the other measures were actually down. Notice also that the broader the average (the more stocks included) the worse it did. Compare the percentage changes. The 30 stock Dow gained .16%. The S&P 500 lost .07%. The Nasdaq Composite, which includes more than 5,000 stocks, was the day's worst performer and lost .92%. Almost as bad as the Nasdaq was the Russell 2000 (–.89%), which is a measure of 2000 small cap stocks. The message in this brief comparison is that even though the Dow gained on the day, the overall market lost ground as measured by the more broader based stock averages. We'll revisit the idea of comparing market averages again. But first, let's show the different ways market technicians can analyze the market's breadth numbers.
THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is positive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market averages are trending in the same direction.
THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street Journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is positive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market averages are trending in the same direction. THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street Journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is positive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market averages are trending in the same direction.
AD DIVERGENCE
What does the advance-decline line measure? The advance-decline line tells us whether or not the broader universe of 3500 NYSE stocks is advancing in line with the most widely followed stock averages, which include only the 30 Dow Industrials or the 500 stocks in the S&P 500. To paraphrase a Wall Street maxim: the advance-decline line tells us if the "troops" are keeping up with the "generals." As long as the AD line is advancing with the Dow Industrials, for example, the breadth or health of the market is good. The danger appears when the AD line begins to diverge from the Dow. In other words, when you have a situation where the Dow Industrials are hitting new highs while the broader market (measured by the AD line) isn't following, technicians begin to worry about "bad market breadth" or an AD divergence. Historically, the AD line peaks out well ahead of the market averages, which is why it's watched so closely.
DAILY VERSUS WEEKLY AD LINES
The daily AD line, which we have described herein, is better used for short to intermediate comparisons with the major stock averages. It is less useful for comparisons going back several years. A weekly advance-decline line measures the number of advancing versus declining stocks for the entire week. Those figures are published in Barron's each weekend. A weekly advance-decline line is considered more useful for trend comparisons spanning several years. While a negative divergence in the daily AD line may warn of short to intermediate problems in the market, it's necessary to also show a similar divergence in the weekly AD line to confirm that a more serious problem is developing.
VARIATIONS IN AD LINE
Since the number of stocks traded on the NYSE has grown over the years, some market analysts believe the method of subtract‑
ing the number of declining issues from the number of advancing issues gives greater weight to the more recent data. To combat that problem, many technicians prefer to use an advance/decline ratio which divides the number of advancing issues by the number of declining issues. Some also believe that there's value in including the number of unchanged issues in the calculation. Whichever way the AD line is calculated, its use is always the same—that is, to measure the direction of the broader market and to ensure it's moving in the same direction as the more narrowly constructed, but popular market averages. Advance decline lines can also be constructed for the American Stock Exchange and the Nasdaq Market. Market technicians like to construct overbought/oversold oscillators on the AD lines to help measure short to intermediate term market extremes in the breadth figures themselves. One of the better known examples is the McClellan Oscillator.
McCLELLAN OSCILLATORDeveloped by Sherman McClellan, this oscillator is constructed by taking the difference between two exponential moving averages of the daily NYSE advance-decline figures. The McClellan Oscillator is the difference between the 19 day (10% trend) and the 39 day (5% trend) exponential moving averages of the daily net advance decline figures. The oscillator fluctuates around a zero line with its upper and lower extremes ranging from +100 and –100. A McClellan Oscillator reading above +100 is a signal of an overbought stock market. A reading below –100 is considered an oversold stock market. Crossings above and below the zero line are also interpreted as short to intermediate term buying and selling signals respectively McCLELLAN SUMMATION INDEXThe Summation Index is simply a longer range version of the McClellan Oscillator. The McClellan Summation Index is a cumulative sum of each day's positive or negative readings in the McClellan Oscillator. Whereas the McClellan Oscillator is used for short to intermediate trading purposes, the Summation Index provides a longer range view of market breadth and is used to spot major market turning points. NEW HIGHS VERSUS NEW LOWS
In addition to the number of advancing and declining stocks, the financial press also publishes the number of stocks hitting new 52 week highs or new 52 week lows. Here again, these figures are available on a daily and weekly basis. There are two ways to show these figures. One way is to plot the two lines separately. Since the daily values can sometimes be erratic, moving averages (usually 10 days) are plotted to present a smoother picture of the two lines. (See Figure 18.4.) In a strong market, the number of new highs should be much greater than the number of new lows. When the number of new highs start to decline, or the number of new lows start to expand, a caution signal is given. A negative market signal is activated when the moving average of new lows crosses above.
the moving average of new highs. It can also be shown that whenever the new highs reach an extreme, the market has a topping tendency. Similarly, whenever new lows reach an extreme, the market is near a bottom. Another way to use the new highs versus new lows numbers is to plot the difference between the two lines.
NEW HIGH-NEW LOW INDEXThe advantage of a New High-New Low index is that it can be directly compared to one of the major market averages. In that way, the high-low line can be used just like an advance-decline line. (See Figure 18.5.) The trend of the high-low line can be chart
and it can be used to spot market divergences. A new high in the Dow, for example, that is not matched by a corresponding new high in the high-low line could be a sign of weakness in the broader market. Trendline and moving-average analysis can be applied to the line itself. But its major value is in either confirming or diverging from the major stock trends and giving early warning of potential trend changes in the overall market. Dr. Alexander Elder describes the New High-New Low index as "probably the best leading indicator of the stock market" Trading for a Living, (Wiley).
Elder suggests plotting the indicator as a histogram with a horizontal reference point at its zero line, making divergences easier to spot. He points out that crossings above and below the zero line also reflect bullish and bearish shifts in market psychology.
UPSIDE VERSUS DOWNSIDE VOLUME
This is the third and final piece of data that is utilized to measure the breadth of the market. The New York Stock Exchange also provides the level of volume in both the advancing and declining issues. That data is also available the next day in the financial press. It is then possible to compare the upside volume versus the downside volume to measure which is dominant at any given time. (See Figure 18.6.) The upside volume and downside volume can be shown as two separate lines (just as we did with the new highs and new lows figures) or the difference can be shown as a single line. Either way, the interpretation is always the same. When the upside volume is domi‑ss nant, the market is strong. When downside volume is greater, the market is weak. It's possible to combine the number of advancing and declining issues with advancing and declining volume. That's what Richard Arms did in the creation of the Arms Index.
THE ARMS INDEX
The Arms Index, named after its creator Richard Arms, is a ratio of a ratio. The numerator is the ratio of the number of advancing issues divided by the number of declining issues. The denominator is the advancing volume divided by declining volume. The purpose of the Arms Index is to gauge whether there's more volume in rising or falling stocks. A reading below 1.0 indicates more volume in rising stocks and is positive. A reading above 1.0 reflects more volume in declining issues and is negative. On an intraday basis, a very high Arms Index reading is positive, while a very low reading is negative. The Arms Index, therefore, is a contrary indicator that trends in the opposite direction of the market. It can be used for intraday trading by tracking its direction and for spotting signs of short term market extremes. (See Figure 18.7.)
TRIN VERSUS TICK
The Arms Index (TRIN) can be used in conjunction with the TICK indicator for intraday trading. TICK measures the difference between the number of stocks trading on an uptick versus the number trading on a downtick. The TICK is a minute-by-minute version of the daily advance-decline line and is used for the same purpose. When combining the two during the day, a rising TICK indicator and a falling Arms Index (TRIN) are positive, while a falling TICK indicator and a rising Arms Index (TRIN) are negative. The Arms Index, however, can also be used for longer range analysis.
SMOOTHING THE ARMS INDEX
While the Arms Index is quoted throughout the trading day and has some short term forecasting value, most traders use a 10 day moving average of its values. According to Arms himself, a 10 day average of the Arms Index above 1.20 is considered oversold, while a 10 day Arms value below .70 is overbought, although those numbers may shift depending on the overall trend of the market. Arms expresses a preference for Fibonacci numbers as well. He suggests using a 21 day Arms Index in addition to the 10 day version. He also utilizes 21 day and 55 day moving-average crossovers of the Arms Index to generate good intermediate term
trades. For more in-depth treatment, read The Arms Index (TRIN) by Richard W. Arms, Jr.
OPEN ARMS
In calculating the 10 day Arms Index, each day's closing value is determined using the four inputs and that final value is smoothed with a 10 day moving average. In the "Open" version of the Arms Index, each of the four components in the formula is averaged separately over a period of 10 days. The Open Arms Index is then calculated from those four different averages. Many analysts prefer the Open Arms version to the original version. Different moving average lengths, like 21 and 55 days, can also be applied to the Open Arms version. EQUIVOLUME CHARTINGAlthough Arms is best known for creating the Arms Index, he has also pioneered other ways of combining price and volume analysis. In doing so, he created an entirely new form of charting called Equivolume. In the traditional bar chart, the day's trading range is shown on the price bar with the volume bar plotted at the bottom of the chart. Since technical analysts combine price and volume analysis, they have to look at both parts of the chart at the same time. On the Equivolume chart, each price bar is shown as a rectangle. The height of the rectangle measures the day's trading range. The width of the rectangle is determined by that day's volume. Heavier volume days produce a wider rectangle. Lighter volume days are reflected in a narrower rectangle.As a rule, a bullish price breakout should always be accompanied by a burst of trading activity. On an Equivolume chart, therefore, a bullish price breakout should be accompanied by a noticeably wider rectangle. Equivolume charting combines price and volume analysis into one chart and makes for much easier comparisons between price and volume. In an uptrend, for example, up days should see wider rectangles while down days should see narrower rectangles. Equivolume charting can be applied to market averages as well as individual stocks and can be plotted for both daily and weekly charts. For more information, consult Volume Cycles in the Stock Market by Richard Arms (Dow Jones-Irwin, 1983).
CANDLEPOWER
In Chapter 12, Greg Morris explained candlestick charting. In a 1990 article published in Technical Analysis of Stocks and Commodities magazine entitled "East Meets West: CandlePower Charting," Morris proposed combining candlestick charts with Arms' Equivolume charting method. Morris' version shows the candlestick chart in an Equivolume format. In other words, the width of the candlestick is determined by the volume. The greater the volume, the wider the candlestick. Morris called the combination CandlePower charting. Quoting from the article: ". . . the CandlePower chart offers similar if not better information than Equivolume or candlestick charting and is as visually appealing as either of them." Morris' CandlePower technique is available on Metastock charting software (published by Equis International, 3950 S. 700 East, Suite 100, Salt Lake City, UT 84107 [800] 8823040, www.equis.com). However its name has been changed to Candlevolume.
COMPARING MARKET AVERAGES
At the start of the chapter, we mentioned that another way to gauge market breadth was to compare the different market averages themselves. We're talking here primarily about the Dow Industrials, the S&P 500, the New York Stock Exchange Index, the Nasdaq Composite, and the Russell 2000. Each measures a slightly different portion of the market. The Dow and the S&P 500 capture the trends of a relatively small number of large capitalization stocks. The NYSE Composite Index includes all stocks traded on the New York Stock Exchange, and gives a slightly broader perspective. Breakouts in the Dow Industrials should, as a rule, be confirmed by similar breakouts in both the S&P 500 and the NYSE Composite Index if the breakout is to have staying power.
450 Chapter 18
Most important divergences involve the Nasdaq and the Russell 2000. The Nasdaq Composite has the largest number of stocks (5000). However, since the Nasdaq is a capitalization-weighted index, it is usually dominated by the one hundred largest technology stocks like Intel and Microsoft. Because of that, the Nasdaq is more often a measure of the direction of the technology sector. The Russell 2000 is a truer measure of the smaller stock universe. Both indexes, however, should be trending upward along with the Dow and the S&P 500 if the trend of the market is truly healthy.Relative strength (RS) analysis plays a useful role here. A ratio of the Nasdaq to the S&P 500 tells us whether the technology stocks are leading or lagging. It's usually better for the market if they're leading and the ratio line is rising. comparison of the Russell 2000 and the S&P 500 tells us whether the "troops" are following the "generals." When the small stocks are showing poor relative strength, or are lagging too far behind the large stocks, that's often a warning that market breadth is weakening.CONCLUSION
Another example of comparing two market averages for signs of confirmation or divergence involves the Dow Theory. In Chapter 2, we discussed the importance of the relationship between the Dow Industrials and the Dow Transports. A Dow Theory buy signal is present when both averages hit new highs. When one diverges from the other, a caution signal is given. It can be seen then that the study of market breadth, and the related issues of confirmation and divergence, can take many forms. The general rule to follow is that the greater the number of stock market averages that are trending in the same direction, the greater the chances are for that trend continuing. In addition, be sure to check the advance-decline line, the new highs-new lows line, and the upside-downside volume lines to make sure that they're also trending in the same direction.
Comment Form under post in blogger/blogspot