Finding Strength in (Stock Chart) Numbers

When you compete, it’s typically a good thing to be the last person standing. But in trading, the last person standing is the greater fool because the psychology of greed and fear continually play out by missing bottoms and buying tops. If you can relate to this, you may find adding market-breadth indicators into your trading habits may help you break the buy-high-and-sell-low cycle.

Market breadth measures the degree to which a majority of stocks are participating with a market’s trend. For example, the S&P 500 may have an up day. But, if a majority of stocks are down, or there is more volume on stocks that declined, you might interpret this as bad news. Breadth is typically used to identify possible divergences in the market, rather than confirming the strength or weakness seen in an underlying market trend.

Advancing vs. Declining Issues

The New York Stock Exchange (NYSE) is one popular exchange to monitor for breadth because of its strict listing requirements, size, and diversity. If you follow a capitalization-weighted index like the S&P 500, you’ll find certain stocks will count more than others because of their size. By considering the number of stocks advancing (moving up), versus the number of stocks declining (going down), you’ll be equally weighting each stock. This eliminates the potential bias of a few large stocks carrying the index. You’ll find lots of ways to view this information. But, for our discussion we’re going to be using a ratio of advancing-to-declining issues.

In the upper chart in Figure 1, you’ll see the NYSE Advancing Issues ($ADVN) plotted against a relative-strength study of Declining Issues ($DECN). The left scale is the value for the relative strength line and represents a ratio of advancing-to-declining issues. The area highlighted tracks the market swoon following the last debt-ceiling negotiation, and subsequent debt downgrade in 2011. This is a key area for some traders, but before we get to that, let’s talk about volume.

Up vs. Down Volume

You may have heard volume precedes price. This idea is that volume will typically increase ahead of a significant price move. From our breadth perspective, using the volume of the advancing and declining issues on the NYSE may give you a heads up when a trend changes. Or it might at least confirm the trend. Up volume is comprised of the aggregate total of volume across all advancing issues on the NYSE for a given period, and vice versa for down volume.

The lower chart of Figure 1 is similar to that of the upper chart—except that the NYSE Advanced Volume ($UVOL) is used instead of $ADVN, and NYSE Declined Volume ($DVOL) replaces $DECN in the study. You can arrange both charts for bearish indications by reversing the order of the symbols.

The Punchline

You may have heard traders use the term “90% day (Figure 1).” A bullish 90% day is when there is nine times the volume of advancing to declining stocks, and 9 times the amount of up volume to down volume. The opposite would be true for bearish 90% days. You’ll notice that between August 9th to the 15th, three out of five days were 90% days. This may have provided an early bullish signal that breadth was improving.

While these types of divergences should not be your sole trading signal, as a technician it’s important to approach the market systematically and know what your market posture is. Using breadth indicators may give you more confidence to know that you’re not alone.