When the Nifty 50 or the Sensex moves up, it’s often considered a good sign for market participants. The common belief is that if a broad market index rises in value, it must mean that the market itself is on an uptrend. However, the Nifty 50, Sensex, and other benchmark indices consist of multiple stocks.
And while some or most of these stocks may rise to pull the value of the index upward, other stocks in the index may be declining. You can use the advance-decline ratio to get a true picture of the index or market movement and what drives it.
What is the advance-decline ratio?
The advance-decline ratio (ADR) is a technical indicator comparing the number of advancing and declining stocks in any given index or exchange. Advancing stocks are those that closed at a higher price today than their closing prices on the previous trading day. Declining stocks are those that closed at a lower price today than the previous trading day’s closing prices.
With the help of the advance-decline indicator, you can gain valuable insights about the market breadth. The market breadth tells you how many stocks are participating in the movement of an index or exchange. For instance, only a handful of the biggest stocks in an index may be bullish, thus driving the index’s value up. But most of the smaller stocks in the index may be declining. You can only discover this nuance by using a market breadth indicator like the ADR.
How does the advance-decline ratio work?
The advance-decline ratio measures market breadth. It compares the number of advancing stocks to declining ones. This comparison offers information related to the overall market sentiment and the strength of trends. For more clarity, let’s check out how the advance-decline ratio works:
Market sentiment indicator
- A ratio greater than 1 indicates that more stocks are advancing than declining, suggesting a bullish market sentiment. Conversely, a ratio less than 1 indicates a bearish market sentiment with more stocks declining than advancing.
Market breadth analysis
- The ADR is a breadth indicator that helps in understanding the market's overall health. A market with a high ADR signifies broad-based participation in the upward movement, which is typically seen as a positive sign. Conversely, a low ADR can indicate weak market breadth, even if major indices are rising, which might suggest a potential market correction.
Trend confirmation
- Analysts use the ADR to confirm the sustainability of a market trend. For instance, if a stock index is climbing but the ADR is falling, it may indicate that the rally is losing momentum as fewer stocks are participating in the rise.
Divergence signals
- Divergences between the ADR and market indices can provide early warning signals. For example, if an index is making new highs but the ADR is declining, it suggests that fewer stocks are contributing to the rise, which might be a sign of an impending reversal.
Formula to calculate advance-decline ratio
Today, the ADR is easily available online for most indices and exchanges. For instance, you can find the daily and monthly advance-decline ratio of the NSE stocks on the exchange's official website. Nevertheless, it helps to know how to compute the ADR yourself.
The formula for calculating the ratio is as follows:
Advance Decline Ratio = Number of Advancing Stocks ÷ Number of Declining Stocks |
For example, let’s say on July 6, 1,380 stocks on the NSE advanced while 905 declined. In that case, the ADR will be 1.52 (1,380 ÷ 905). And let’s say on July 7, only 876 stocks on the exchange advanced as opposed to 1,419 stocks that declined. In this case, the advance-decline ratio of the NSE stocks will be 0.62 (876 ÷ 1,419).
Importance of the advance-decline ratio
Most traders use the advance-decline ratio to assess market sentiment and identify trend reversals. Also, it helps to confirm the strength of ongoing trends. Let’s check this indicator out in detail:
● Market sentiment indicator
The advance-decline ratio compares the number of stocks that are rising (advancing) to those that are falling (declining). When this ratio is high, it shows that more stocks are gaining value. This situation indicates a bullish market. On the other hand, a low ratio suggests that more stocks are losing value, signalling bearish market conditions.
● Identifying divergences
It must be noted that “divergences” occur when the A/D ratio moves in the opposite direction of a major market index. For example, assume a situation where the index is climbing, but the A/D ratio is dropping. Now, this is possibly a warning sign that only a few stocks are driving the index up. Also, it suggests a weakening trend and a likely market reversal.
● Trend confirmation
The A/D ratio is also used to confirm the strength of market trends. In an uptrend, a rising A/D ratio suggests that the trend is strong. Usually, in this situation, it is supported by a broad base of advancing stocks. On the other hand, during a downtrend, a declining A/D ratio confirms the bearish sentiment. Here, it indicates that the downward movement is likely to continue.
How traders and investors use the advance-decline ratio?
It is worth mentioning that the advance-decline ratio is a versatile tool. It helps both short-term traders and long-term investors make informed decisions by analysing market trends and sentiment. Let’s see how:
● Short-term trading
For short-term traders, the A/D ratio offers a snapshot of daily market conditions. By tracking the daily A/D ratio, traders can quickly gauge whether the market is bullish or bearish. This information helps in making fast trading decisions.
For example, say the Nifty 50 shows a high A/D ratio at the market’s opening. This situation indicates more advancing than declining stocks. Now, a day trader might take this as a sign to go long. They can anticipate a bullish trend throughout the day.
● Long-term investment
Long-term investors use the A/D ratio to evaluate the overall health of the market over a longer time frame. A consistently rising A/D ratio over several months suggests that a broad base of stocks is gaining value. Usually, this signals a strong market trend.
For example, say the midcap index shows a steadily increasing A/D ratio over several months. This indicates a solid investment opportunity in midcap stocks. That’s because the trend suggests strength in this segment of the market.
What the advance-decline ratio (ADR) tells you
Once you’ve understood how to use the advance-decline indicator, you need to know how to interpret the ratio. The pointers outlined below offer clarity on what the ADR tells you.
1. Market trend signals
The most fundamental aspect the ADR sheds light on is the prevailing market trend. If the ratio is greater than 1, it indicates that more stocks are advancing than declining. This is a bullish signal. On the other hand, if the advance-decline ratio is less than 1, it means more stocks are declining, which is a bearish signal.
2. Rallies vs. sell-offs
By comparing the moving averages of the ADR with the index or the exchange concerned, you get a clear idea of the number of stocks driving the overall performance of the index/market. If a vast majority of stocks are pushing the index upward, it could indicate a rally. But if most stocks are declining and pulling the index down, it could signal a sell-off.
3. Oversold vs. overbought markets
A high advance-decline ratio generally means that the market is overbought — or, in other words, overvalued. This means there may be a potential market correction in the future, where the overvaluation is rectified through a bearish trend. Similarly, a high ADR may signal an oversold or undervalued market, indicating an impending bullish trend.
The advance-decline line
The advance-decline line is a graphical representation of the ADR. It is calculated cumulatively. This means that to plot today’s values on the graph, you need to take today’s net advances and increase this value by the previous day’s advances, if any. The net advances are also called the AD line value.
The formula for computing the AD line value on any given trading day is as follows:
AD Line Value Today = Number of Advancing Stocks Today - Number of Declining Stocks Today + Previous AD Line Value |
The table below should give you more clarity on how to calculate the advance-decline line value.
Trading day |
Number of advancing stocks |
Number of declining stocks |
Previous day’s ad line value |
Today’s AD Line Value |
1 |
1500 |
1325 |
0 |
175 |
2 |
1125 |
1700 |
175 |
- 400 |
3 |
825 |
2000 |
- 400 |
775 |
4 |
2007 |
818 |
775 |
1964 |
5 |
1122 |
1703 |
1964 |
1383 |
Advantages of the ADR
The advance-decline ratio (ADR) helps traders and investors understand the overall market sentiment. It offers several key advantages in identifying the likely trend reversals and confirming trend strength. Let’s understand some major advantages of ADR in detail:
1. Market breadth analysis:
- The ADR provides a clear picture of the overall market breadth, indicating whether a broad or narrow range of stocks is driving the market movements. A higher ADR suggests widespread participation in the market rally, while a lower ADR points to a lack of breadth in market advances.
2. Trend confirmation:
- The ADR helps in confirming market trends. For instance, a rising market index accompanied by a rising ADR confirms the uptrend as more stocks are advancing. Conversely, a declining market index with a declining ADR reinforces the downtrend.
3. Early warning signals:
- Divergences between the ADR and market indices can serve as early warning signals for potential market reversals. If an index is making new highs but the ADR is declining, it indicates weakening market breadth, which may precede a market downturn.
4. Simplicity and ease of calculation:
- The ADR is straightforward to calculate and interpret. This simplicity makes it accessible for both novice and experienced traders, providing a quick snapshot of market sentiment without the need for complex analysis.
5. Daily insights:
- The ADR can be used on a daily basis to gauge short-term market sentiment. This daily analysis is beneficial for day traders and short-term investors looking to make timely trading decisions based on current market conditions.
Disadvantages of the ADR
While the advance-decline ratio is a useful tool, it also has some limitations, such as potential false signals and difficulty in interpreting, especially in volatile markets. Moreover, as a major drawback, it heavily relies on broader market conditions. Let’s understand some major disadvantages of ADR in detail:
1. False signals in volatile markets:
- The ADR can sometimes produce false signals in highly volatile markets. Sudden market movements due to news events or economic reports can cause temporary distortions in the ADR, leading to misleading interpretations.
2. Lagging indicator:
- As a lagging indicator, the ADR may not always provide timely signals for market entry or exit. It often reflects past market conditions rather than predicting future movements, which can be a limitation for traders seeking to anticipate market changes.
3. Not a standalone indicator:
- While useful, the ADR should not be relied upon in isolation. It is most effective when used in conjunction with other technical indicators and analysis methods. Relying solely on the ADR can lead to incomplete or inaccurate market assessments.
4. Sectoral bias:
- The ADR may exhibit sectoral bias if certain sectors dominate the market. For example, if a few large-cap stocks in a specific sector are advancing significantly, it can skew the ADR, masking the performance of other sectors.
5. Short-term focus:
- The ADR is generally more effective for short-term analysis and may not provide reliable insights for long-term investment decisions. Long-term investors need to consider a broader range of factors beyond the ADR to make informed investment choices.
Conclusion
This sums up the fundamentals of the advance-decline ratio and how you can use it to interpret the overall market sentiment. However, as is the case with all technical indicators, this ratio must never be used on a standalone basis. It is best to combine the advance and decline metrics with other tools like moving averages and volume trend indicators to get a more comprehensive idea of the forces driving the market in any given direction.
