Breadth of Market Theory

What Is Breadth of Market Theory?

The breadth of market theory is a technical analysis methodology that measures the strength of the market according to the number of stocks that advance or decline in a particular trading day, or how much upside volume there is relative to downside volume.

The breadth of market theory is the basis for the breadth of market indicator.

Understanding Breadth of Market Theory

There are numerous ways to analyze market breadth, which is a measure of the power of the stock market as a whole. The overall heartiness of the stock market may not be evident by just seeing major market indexes, for example, the S&P 500, Nasdaq 100, or Dow Jones Industrial since these indexes just hold a select group of stocks.

Breadth is typically a measure of the number of stocks that are advancing relative to the number declining. Alternatively, it may also include volume studies, for example, volume in rising stocks versus volume in falling stocks.

Advance/decline indicators measure the number of stocks advancing and declining for the afternoon. On the off chance that the breadth indicator is rising over the long run, this indicates the market is strong and the rise in the index is sustainable. For example, in the event that a market is comprised of 150 stocks and 95 stocks experience price gains while 55 stocks either experience no change or decline in price, according to the breadth of market theory, the market is as of now considered strong or rising.

If the advance/decline falls while major stock indexes rise, this indicates that less stocks are participating in the rally and could forewarn of a fall in the indexes. As increasingly few stocks rise, the index's performance will eventually start to endure as well.

Breadth indicators are not accurate timing signals. While they may warn of a decline, they don't indicate when it will happen. Similarly, a rise in the breadth indicator while the major indexes are declining warns that buying pressure is building and the indexes may start to rise soon, however it doesn't let us know when.

Special Considerations

Breadth indicators frequently act in tandem with the price moves in indexes. For example, a rise in the index sees a rise in the breadth indicator. This is called confirmation. At the point when the breadth indicator diverges it warns of a potential change in the index direction. Changes in index direction are not always forewarned by the breadth indicators.

Market breadth takes a gander at the number of stocks that are advancing and declining (and volume) to determine how strong the stock market is. Dow Theory also takes a gander at the vigor of the market yet utilizes different devices. One of the precepts of Dow Theory, and there are several, is that industrial and transportation indexes should affirm each other. At the point when the two are moving this way and that it could signal difficulty.

Popular Breadth of Market Indicators

Two popular market breadth methods include the Advance/Decline ratio (ADR) and the Advance/Decline line (A/D line).

The ADR compares the number of stocks that closed higher against the number of stocks that closed lower than their previous day's closing prices. To calculate the advance/decline ratio, the number of advancing stocks is divided by the number of declining stocks. The advance/decline ratio is typically calculated daily.

The A/D line plots changes in advances and declines consistently and the outcome is cumulative. Each data point is calculated by taking the difference between the number of advancing and declining issues and adding the outcome to the previous period's value, as shown by the accompanying formula:

A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Previous Period's A/D Line Value

More limited term breadth indicators include the tick index and the Arms index (TRIN). The tick index compares the number of stocks making a uptick versus a downtick. This is an intraday indicator. The Arms index compares the advance/decline ratio to advancing/declining volume.

Other breadth indicators include On Balance Volume (OBV), Up/Down Volume Ratio, and the McClennan Summation Index.

Breadth of Market Theory Example

The S&P 500 could be compared with the NYSE A/D line to monitor underlying strength or weakness. The NYSE A/D line is seeing all stocks listed on the NYSE, while the S&P 500 is just tracking a select group of 500 stocks. The NYSE A/D line provides a broader measure of how most stocks are doing.

The chart below shows the SPDR S&P 500 ETF (SPY) along with the NYSE A/D line. In early 2018 the S&P 500 was moving lower, yet in April the NYSE A/D line was making new highs. The S&P 500 was not even close to its highs, yet ultimately the index followed suit and made new highs like the A/D line.

Yet again in early and mid-2019, the NYSE A/D line moved above prior highs in advance of SPY moving above corresponding highs. The S&P 500 followed suit and eclipsed the prior highs.

Breadth of Market Theory Limitations

Breadth of market theory is checking historical data out. Like any data, new data could come in to invalidate the old. For instance, a trader may exit long positions as the index goes up yet breadth indicators decline. The index may keep going up, and the breadth indicators may start going up as well to affirm.

Breadth indicators are not timing signals. While they provide beneficial information about the state of the market, they don't signal when it will decline. For that, traders need to watch price action. Breadth indicators can provide forewarning, yet price action will provide the actual trade signals.

Breadth indicators are best used related to price action, and different forms of analysis, to determine buy and sell signals.

Features

• Breadth indicators take a gander at the number of advancing stocks versus declining stocks, or advancing volume versus declining volume.
• At the point when a breadth indicator diverges with a stock index, it may warn of a potential change in the direction in the index.
• The breadth of market theory utilizes breadth indicators to assist with assessing whether major stock indexes are probably going to rise or fall.
• A rising breadth indicator, where advancing stocks and advancing volume is outpacing declining stocks and declining volume, is generally considered positive at a cost advance in the stock indexes.