Market Insights: Market Indicators You Should Know [Part 2]

Welcome back! Let's continue our discussion on market sentiment indicators. Remember from last week that a market sentiment indicator is just what it sounds like: an indicator that helps gauge market sentiment regarding bullishness vs. bearishness. Last week, we looked at what the S&P 500 (SPX) was doing:

And compared that to the Put-Call Ratio indicator with a baseline around 0.85:

Today, I want to add another market sentiment indicator to our toolbox: the Advance/Decline Line or ADL. The ADL is another popular indicator that measures market sentiment. However, instead of using call and put options like the Put/Call Ratio does, the Advance/Decline Line measures the number of stocks making higher closes or advances minus the number of stocks making lower closes or declines. That looks something like this:

Generally, as the market is rising, the ADL will be increasing as well, and it will be decreasing as the market is falling. However, it's important to note when there are divergences in the data. For example, a rising ADL during a market selloff may indicate an imminent reversal.

Similarly, a decreasing ADL during a rising market may indicate that the market is losing steam, which we appear to be seeing in the chart above. Notice that the market is still making new highs, while the ADL is decreasing for the second day in a row. We may be in for a short-term top until more stocks begin closing higher again.

Actually, there are two different indicators that you can use with this data. The first is the Advance/Decline Line, which gives you a line indicating the net change in advances and declines from period to period. That's what we looked at above.

The second is the Advance/Decline Ratio, which divides the number of advances by the number of declines and gives you a ratio of advances to declines. A ratio of 1.0 indicates an equal number of advancing stocks to declining stocks, and a ratio greater than 1.0 indicates more advances, while a ratio less than 1.0 indicates more declines.

This indicator is less about the trend of the line and more about identifying potentially overbought or oversold conditions in the market. It looks something like this:

Notice that the ratio is more often above 1.0 than not. This means that the market is usually seeing more stocks closing higher than lower, which makes sense since the market historically goes up over time.

Also, look at the major spikes and troughs in the ADR above and the index's price action at those times. Note that this indicator isn't necessarily showing us divergence or reversals like the ADL might. Instead, we're identifying market sentiment, as peaks in the ADR tend to coincide with large buying days in the index.

Similar to the ADL, notice that the ratio also tells us that there have been less and less stocks making advances in the last few days even while the market has been climbing higher. Again, we might see a short-term pullback here soon unless more stocks start making new highs.

It's important to realize that none of these indicators should be used alone, nor should any of them be taken as gospel. Making a trading decision based on a single indicator would probably be a terrible idea that will likely lead to losses.

Instead, we want to compare multiple indicators and make decisions based on several combined data points. If we have many "lights" all flashing the same signal, then it is something that we should at least seriously consider.

As I said before, both the ADL and ADR are simply another tool to add to your analysis toolbox. Advances/Declines is an important indicator to keep an eye on moving forward, and when you see divergence or extreme levels, it might be prudent to consider your next steps carefully.

As always, it is critical to follow a solid trading plan no matter what indicators you use. Conducting proper analysis, structuring your trades for asymmetric returns, and managing your risk wisely will help you make money in any market environment. Until next week! Happy trading!