Advance/Decline Quotes

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Many traders and investors have heard about "advance and decline indicators" (AD indicators), but are held back by the common misconception that these technical studies are available only to professional traders working for large financial institutions or fund companies. Such is not the case, however, and that is why we have compiled this small tutorial. It introduces you to the basic principles behind these indicators. You will learn what they mean, how they work, and how you can apply them to your trading.

Before we proceed, it is important to understand that no indicator can tell you when to buy and sell with 100% accuracy. It is a fact of trading that all indicators are fallible to some degree. Let us start a discussion of what a hypothetical "ideal indicator" would look like. An ideal indicator would give you a clear, infallible signal every time the market reaches a "critical level" from where it would then reverse. An ideal indicator could also be configured for short-, mid-, or long-term trading, giving only signals relevant to the particular timeframe you may wish to trade. It would also tell us with precision, at every point during the trading day, what a majority of traders wishes to do. Do they want to buy now? Are they willing to buy even at higher prices (i.e., are they willing to bid stocks higher? During an up-trend, the majority of traders / investors demand more stock. If this demand persists, it can only be satisfied by higher share prices).

To know all this (and to know it at every point during the trading day), one would need to see how many buy and sell orders are "on the books", where exactly bids and asks are located, for how many shares, and when market orders are likely to come, and all this information would constantly need to be updated. While some of this data is available (market book, NASDAQ Level II quotes), much of it is not and nobody can see a market order come in unless they are the one who placed it themselves.

While there is no such thing as our hypothetical "ideal indicator", the indicators based on the advances/declines concept are among the best tools available today. Used and interpreted correctly, AD indicators are excellent tools you can use to anticipate points at which the market becomes "overbought" or "oversold" (for a given timeframe: short-, mid-, or long-term). Once a market has reached an "overbought" or "oversold" state, it is more likely to reverse its trend. A word of caution here: reaching "overbought" or "oversold" levels does not necessarily imply that the market will actually reverse; it is just statistically more likely to do so. In the markets, there exists a most powerful force called "sentiment". At times, extremes in market sentiment can extend an ongoing trend (up or down) beyond what most think is possible, reasonable, or even imaginable! When such extremes occur, most indicators become practically useless for the time being. The best indicators available today only serve to identify when the market has hit that critical point - the rest is up to you. If an indicator reaches the critical point, yet the market trend continues unabated, be on the ready for sudden reversals at any time.

It does not mean that there is anything wrong with the indicator; rather, it tells you that your assumptions about the situation were faulty. You have to go back, reassess, reanalyze, and adjust your trading strategy accordingly. To be able to do this, you must of course already have your own trading strategy - a strategy that suits your personal risk tolerance and the amount of money you have available for trading. Further, you should be very familiar with the specific technical indicators you use and know how they fit in with your personal style of trading, as well as your favorite timeframe (focus timeframe: whether intraday scalper, day trader, swing trader, position trader, long-term trader, etc.)

You have to understand that having a written trading plan, a well-formulated trading strategy, and most of all, the discipline to follow them will account for 80% of your trading success. Adhering to your own stop-loss system will help you prevent large losses. If you get stopped out from a losing position, you will then have the opportunity to analyze and reassess the trade and learn from your mistakes. If you do not have the above, you will find yourself relying too heavily on your emotions. The danger is that you will always find an excuse to explain your losses or put the blame on your technical indicators, but never on yourself.

As we said, there is no "ideal indicator". But you can approach the ideal if you use those indicators that match your trading strategy, apply what you know with discipline, and be willing to adjust your analysis when trades go against you.

In our small tutorial, we provide examples illustrating the use of the AD indicators. We will cover some specific market situations to help you better understand the underlying mechanisms of the AD indicator, plus we show you, how to analyze the indicators and how to make trading decisions based on them.

A large part of our tutorial is devoted to defining the indicators themselves. In our opinion, it is extremely important to get a clear grasp on the exact meaning of the words one uses to quantify the market and predict its future moves. Indicators must be clearly (and above all - objectively) defined; otherwise, they serve no real purpose and cause only confusion. What good is it, for example, to hear in the news that "investors are selling and the market is dropping"? The average investor (i.e., not a professional trader) will take this statement to imply that "everyone is selling". On the other hand, a professional trader will view the market from a support/demand perspective and understand that selling pressure is currently greater than buying pressure. He or she understands that this means sellers are motivated to lower their expectations (i.e., they are ready and willing to sell at lower prices), while buyers are not (yet) willing to bid shares higher (i.e., they are waiting for lower prices before jumping in).

What we perceive depends on the meanings we attribute to our definitions, and what we think is happening influences our decisions (and actions). Trading has a very significant psychological / emotional component. Some would say that this aspect of trading is even more important than the use of technical or fundamental analysis or following a trading system. Contrast the following:

• The emotional panic reactions of novice traders: they hear in the news "that everyone is selling out" and therefore decide, they, too, must now sell in order to save their capital;
• The collectedness of serious traders: they use the information about a sell-off as a trigger to study certain indicators, and determine, whether this is likely to be a short-lived correction or something more serious. They are not likely to be "surprised" by information from the press, because they always know exactly where the market is, based on their continuous monitoring of the situation, as it unfolds.

While our tutorial may seem a little bit complicated at first glance, but we believe we have kept it simple enough even for beginning traders. We tried not to delve too deeply into technical issues. We plan to update the tutorial constantly with new examples, so please revisit it repeatedly.

We hope the tutorial will help you trade more successfully with the AD indicators.

Next: Advance/Decline Issues

A. v. S.
V. K.

Copyright 2004 Highlight Investments Group. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

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