What Traders Should Know When Using the Advance/Decline Line
One of the most widely used market strength indicators is the A/D oscillator or more popularly known as the A/D line. This oscillator is primarily used to detect changes in the balance of power from buyers to sellers and vice versa in the stock market e.g. NYSE or NASDAQ. The Oct '72 issue of Commodities Magazine introduced the A/D oscillator which was jointly developed by Larry Williams and James Waters. For a more technical discussion, go to StockCharts A/D Line article.
Theorethical Application of the A/D Line
The A/D line triggers buy and sell signals based on A/D oscillator crossing above and below the zero line. The common and logical deduction is that when the A/D value is above zero, there is accumulation, or in other words, the bulls are in control. Conversely, when the A/D value is below zero the bears have taken control of the market. Another application is the divergence between the A/D Line and the trend of the market. A divergence may indicate a possible turn in the trend.
Actual Behavior of the A/D Line
In real life market trading, the A/D line has an uncanny ability to remain in negative territory for extended periods of time as prices continue to decline. Conversely, it tends also to stay in the positive zone for long periods as prices continue to rally. Back in the NASDAQ rally a.k.a. dot com bubble of the late 1990's, the market leaders were predominantly the dot coms and the NASDAQ Composite Index kept on rallying while the AD line kept going south during the duration of the rally. Another real life characteristic is that the A/D line can whipsaw above and below the zero line many times before a sustained trend emerges. This whipsawing action has the effect of prematurely sucking in buyers or sellers before the trend has eventually changed direction.
How Professional Money Managers Make Decisions Using the A/D Line
The A/D Line is but another tool to gauge the health of the internals of the market. Although the A/D Line may indicate underlying strength or weakness, the market indexes can continue to buck the trend for extended periods. Most money managers know that the indexes such as the DJIA do not represent the entire market. The DJIA, for example, only consists of 30 companies listed at the NYSE. There are many situations in real life when although the indexes are moving higher, the majority of the other stocks are moving lower. In these instances, the general reaction will be to overanalyze what is going on and be paralyzed into not doing anything, or worse, to take a countertrend position hoping for a turn. The professional money or hedge fund managers will instead determine the individual trend of the instrument, be it stocks, index futures or ETFs, and trade accordingly.
The professional fund manager will first determine the established trend by using trend indicators such as MACD and ADX, using price action or just simple trend lines. To get into the actual trade, they would wait for retracements and use tools such as momentum oscillators like RSI and Stochastics to time the actual entry or exits.