Advance/Decline Quotes

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Define Support levels over the Mid-term

In the following article, we are going attempt to define critical levels for the advance/decline (A/D) ratio, in order to find the best entry points for trades.

The following example is addressed to mid-term traders, who are playing only the long side, but the basic principles can of course be adapted to short trades as well.

Below, we make extensive use of two (of our new) volume-based indicators: (1) the advance/decline (AD) issues ratio and (2) the AD volume ratio.

The Advance Decline issues ratio tells us whether the majority of stocks were traded at higher or at lower prices, compared to their previous close.

The AD volume ratio shows the balance of the volume and where the main trading activity was focused.

In order to obtain the most accurate market picture, we strongly believe that these two indicators should always be used together.

The following is a study of the S&P 500 index between October 15, 2003 and October 15, 2004. In the table below, we have compiled those days, on which the highest positive Advance/Decline issues ratios occurred in the S&P 500 index. (You can see that all the values are above 9).

Table1: Highest A/D Issues Ratios in the S&P 500 index.
October 15, 2003 to October 15, 2004.

Date	Advance/Decline Issue Ratio
12/29/2003	16.86
3/12/2004	9.25
3/17/2004	9.76
3/25/2004	9.91
3/29/2004	10.18
5/25/2004	18.04
6/7/2004	22.48
8/10/2004	11.72
8/16/2004	16.14
8/18/2004	10.79
9/2/2004	9.53

Next, we created an overlay, plotting this data on an S&P 500 chart (see Chart 1, below):

Figure 1. Highest A/D Issues Ratios in the S&P 500 index.
October 15, 2003 to October 15, 2004.

From the chart above, you can see that it is difficult to determine support and resistance levels based on these numbers. You can see that the biggest value of 22.5 (recorded on June 7, 2004) appeared close to a resistance level of the mid-term up-trend. But you can also see that high Advance/Decline issues values appear near support points of the mid-term downtrend, as well as in the middle of the up trend.

Now, let us try the same exercise using the reverse approach. This time, we will study the lowest Advance/Decline Issues Ratios that occurred in the S&P 500 index between October 15, 2003 and October 15, 2004. (You can see that all the values are below 0.12). We have compiled this data in Table 2.

An A/D issues ratio of less than 1 means the number of declining issues exceeds the number of advancing issues; we thus call it a "negative" A/D issues ratio. (As an aside, the Advance/Decline issues ratio, by its mathematical nature, cannot have a value below zero.)

Conversely, if the A/D issues ratio takes a value higher than 1, it indicates that the number of advancing issues is greater than the number of declining issues. We then speak of a "positive" A/D issues ratio.

Table 2. Lowest A/D Issues Ratios. S&P 500 index.
October 15, 2003 to October 15, 2004.

Date	Advance/Decline Issue Ratio
3/10/2004	0.12
3/11/2004	0.12
3/22/2004	0.10
4/13/2004	0.06
5/7/2004	0.10
5/17/2004	0.11
8/5/2004	0.05
9/22/2004	0.10

Figure 2. Lowest A/D Issues Ratios in the S&P 500 index.
October 15, 2003 to October 15, 2004.

From the chart above, you can see that the lowest Advance/Decline issues ratios seem to occur with some regularity near index support points, and they seem to fairly reliably precede index reversals to the upside.

For instance, March 22, May 17, and August 5, 2004, represent three instances where the Advance/Decline issues ratio dropped below a critical level. If you study the index movement following these events, you can see that the S&P 500 rebounded sharply after the Advance/Decline issues ratio reached their low levels.

As a consequence, an indicator based on negative Advance/Decline issues ratios seems more suitable and consistent for the detection of support levels than the indicator based on positive A/D Issues Ratios (see definitions above).

However we have other Advance/Decline volume ratio for these days.

As you can see from the table above, the Advance/Decline volume ratio for March 10 and 11, as well as for May 7, 2004 is greater than the Advance/Decline issues ratio for those dates.

We can thus assume from this data that even though the number of declining issues surpassed the number of advancing issues on this day, the balance of advanced and declined volume was not so critical for an index reversal. In other words, in spite the fact that the number of declining issues reached a critical level, the trading activity (i.e., volume) was not critically concentrated in declining sectors. This fact helps us, because we can eliminate those days from the analysis and make our picture more clear.

Figure 3. Critical points of A/D ratio
(a/d issues ratio at the top and a/d volume ratio at the bottom of the square).

Now, based on Fig. 3 above, we can draw some initial conclusions on which to base a trade entry point for mid-term traders - those wishing to play the long side. We can formulate this strategy for the S&P 500 index as follows:

During a well-established down-trend (i.e., after the S&P 500 has been declining for some time), when we see the advance/decline issues ratio fall below 0.11, and when the advance/decline volume ratio falls to around this level as well, we can likely anticipate a reversal to the upside within a few days. The strength and duration of the ensuing up-move will depend on how substantially the index declined - the reversal could this be short-lived, or it might be prolonged.

For instance, the reversals following our indicator lows on March 22, May 17, and August 5, 2004 produced were prolonged as the index had previously suffered a prolonged decline.

On the other hand, the reversals following our indicator lows on April 13 and September 22, 2004 remained short- lived, as the index had not declined substantially.

We could thus formulate a simple trade entry "rule" for a mid-term trade:

"Buy when the advance/decline issues ratio in the S&P 500 index is below 0.12 and the advance/decline volume ratio is also close to this critical level. Anticipate a strong reversal if the previous downtrend was extended ".

We would like to draw your attention to the fact that the research was done during the 1 year time frame (from 10/15/2003 to 10/15/2004). The Market is always changing and similar analysis has to be done on a regular basis in order to remain current. We invite you to research and explore for yourself in order to find the system that will best fit your trading style and requirements.

The same calculation could be done for other indexes such as the NASDAQ 100 , DJI and others, although the numbers could differ from the numbers above.

Next: S&P 500 Mid-Term Trends

A. v. S.
V. K.

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