If you watch the stock market, you must have come across the terms “advance” and ‘decline’, and the associated “advance-decline ratio”. Analysts and experts evoke a multitude of jargon when analysing the market and it can be rather daunting, especially if you are just starting out with trading or investing. But even if you are not too conversant with the bears and bulls and the jargon associated with them, being able to read some key data is crucial. Fortunately, advance-decline ratio can be summed up quite simply. Advances are the number of stocks trading at a higher price than the prices they closed at, at the end of the previous day’s session. Declines, on the other hand, mean the number of stocks that are trading at lower prices than they closed on the previous day.
What it indicates
The advance-decline ratio is simply the number of advancing shares divided by the number of declining shares. The trend of the overall market can be gauged by the number of advances or declines recorded over a given period. It can be calculated for various periods, starting from one day.
The ratio makes it simpler for analysts and traders to explain market movement, since it’s an aggregate view, rather than focusing on individual stocks. It is also useful to get a quick sense of reversal of market trends or emerging trends, which is critical for trading successfully. For instance, a low advance-decline ratio can point towards an oversold market, which means a lot of stocks are trading below their true value. On the other hand, a high advance-decline ratio can mean the market is overbought, that is, a lot of stocks are trading above their true values. These factors, in turn, can signal an impending change in market direction.
However, the ratio alone is not the be all and end all of analysis by any means. Only when it is used together with other relevant metrics does it become a useful tool for market analysis.
Why is it useful?
For do-it-yourself investors, the advance-decline ratio can serve as a good indicator when it comes to stock picking. The ratio is a more accurate way of judging market direction and momentum than just looking at the price change of a particular index. This is because an uptick in the index can be driven by a small number of stocks, giving the false impression that the index has gained. But this may not be true for the broader market, which can be ascertained by looking at how many advances versus declines the index has witnessed in conjunction with price change. If the reading is above 1, it means that more stocks in the given index have shown positive movement; anything below 1 would indicate that more stocks have shown negative movement.
Watching the advance-decline ratio is like having a convenient metre that indicates whether the market is bullish or bearish. While the ratio is paired with other indicators by analysts, even in isolation, it is a quick pointer to the direction of the market.