Day Trading with Stock Indicators

Stock Market Indicators The study of market sectors and individual stocks can be accomplished with certain technical tools- chart patterns, volume analysis, trendlines, moving averages, oscillators, etc.

Those same indicators can also be applied to the major market averages. But there’s another class of market indicators widely employed in stock market analysis whose purpose is to determine the health of the overall stock market by measuring market breadth. The data used in their construction are advancing versus declining issues, new highs versus new lows, and up volume versus down volume.
Some very useful indicators that can be easily accessed are: issues traded, advances, declines unchanged, new highs, new lows, adv vol(000), decl vol(000), total vol(000), closing tick, closing arms. These figures are derived from NYSE data. A similar breakdown is given for the NASDAQ. All of these internal market readings have one intended purpose—to give us a more accurate reading on the health of the overall market that isn’t always reflected in the movement of the Dow itself.
Another way to study the breadth of the market is to compare the performance of the stock averages themselves. Using the same day’s trading as an example, the following data lists the relative performance of the major stock averages: Dow Industrials, S&P 500, NASDAQ Composite, Russell 2000.

The Advance-Decline Line This is the best known of the breadth indicators.

The construction of the advance decline is extremely simple. Each day’s trading on the NYSE produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in the WSJ, and are used to construct a daily advance-decline(AD) line. The most common way calculate the AD line is to take the difference between the number of advancing issues and declining issues. If there are more advances than declines, the AD number for the day is positive. If there are more declines than advances, the AD line for that day is negative. That positive or negative number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market averages are trending in the same direction.
AD Divergence
What does the advance-decline line measure? The advance decline line tells us whether or not the broader universe of 3500 NSYE stocks is advancing in line with the most widely followed stock averages, which include only the 30 Dow Industrials or the 500 stocks in the S&P. As long as the AD line is advancing with the Dow, for example, the breadth or health of the market is good. The danger appears when the AD line begins to diverge from the Dow. Historically, the AD line peaks out well ahead of the market averages, which is why it’s watched so closely.
Daily Versus Weekly AD Lines
The Daily AD line, which we have described herein, is better used for short to intermediate comparisons with the major stock averages. A weekly AD line is considered more useful for tend comparisons spanning several years. While a negative divergence in the daily AD line may warn of short to intermediate problems in the market, it’s necessary to also show a similar divergence in the weekly AD line to confirm that a more serious problem is developing.
Variations In AD Line
Since the number of stocks traded on the NYSE has grown over the years, some market analysts believe the method of subtracting the number of declining issues from the number of advancing issues gives greater weight to the more recent data. To combat that problem, many technicians prefer to use an advance/decline ratio which divided the number of advancing issues by the number of declining issues. Some also believe there is value in including the unchanged issues in the calculations as well. Whichever way the AD line calculated, its use is always the same—to measure the direction of the broader market and to ensure it’s moving in the same direction as the more narrowly constructed, but more popular market averages. Market technicians like to construct overbought/oversold oscillators on the AD lines to help measure short to intermediate term market extremes in the breadth figures themselves. One of the better known examples is the McClellan Oscillator.

McClellan Oscillator
This oscillator is constructed by taking the difference between two exponential moving averages of the daily NYSE advance-decline figures. The McClellan Oscillator is the difference between the 19 day (10% trend) and the 39 day (5% trend) exponential moving averages of the daily net advance decline figures. The oscillator fluctuates around a zero  line with its upper and lower extremes ranging from +100 and -100. A reading above +100 is considered an overbought stock market. A reading below -100 is considered to be an oversold stock market. Crossings above and below the zero line are also interpreted as short to intermediate term buying and selling signals respectively.
McClellan Summation Index
The McClellan Summation Index is a cumulative sum of each day’s positive or negative readings in the McClellan Oscillator. Whereas the McClellan Oscillator is used for short to intermediate trading purposes, the Summation Index provides a longer range view of the market breadth and is used to spot major market turning points.
New Highs Versus New Lows
The financial press also publishes the number of stocks hitting new 52 week highs or new 52 week lows. Here again, these figures are available on a daily and weekly basis. There are two ways to show these figures. One way is to plot the two lines separately. Since the daily values can sometimes be erratic, moving averages (usually 10 days) are plotted to present a smoother picture of the two lines. In a strong market, the number of new highs should be much greater than the number of new lows. When the number of new highs start to decline, or the number of new lows start to expand, a caution signal is given. A negative market signal is activated when the moving average of new lows crosses above the moving average of new highs. It can also be shown that whenever the new highs reach an extreme, the market has a topping tendency. Similarly, whenever new lows reach an extreme, the market is near a bottom. Another way to use the new highs versus new lows numbers is to plot the difference between the two lines.
New High-New Low Index
The advantage of the NH-NL index is that it can be directly compared to one of the major market averages. In that way, the high-low line can be used just like and advance-decline line. The trend of the high –low line can be charted and it can be used to spot market divergences. A new high in the Dow, for example, that is not matched by a corresponding new high in the high-low line could be a sign of weakness in the broader market. Trendline and moving average analysis can be applied to the line itself. But its major value is in either confirming or diverging from the major stock trends and giving early warning of potential trend changes in the overall market.  Dr. Alexander Elder  suggests plotting the indicator as a histogram with a horizontal reference point at its zero line, making divergence easier to spot. He also points out that crossings above and below the zero line also reflect bullish and bearish shifts in market psychology.
Upside Versus Downside Volume
This is the third and final piece of data that is utilized to measure the breadth of the market. The NYSE also provides the level of volume in both the advancing and declining issues. That data is also available the next day in the financial press. It is then possible to compare the upside volume versus the downside volume to measure which is dominant at any given time. The upside volume and downside volume can be shown as two separate lines or the difference can be shown as a single line. When the upside volume is dominant the market is strong, and when the downside volume is dominant the market is weak.

The Arms Index
The Arms Index is a ration of a ratio. The numerator is the ratio of the number of advancing issues divided by the number of declining issues. The denominator is the advancing volume divided by declining volume. The purpose of the Arms Index is to gauge whether there’s more volume in rising or falling stocks. A reading below 1 indicates more volume in rising stocks and is positive. A reading above 1 reflects more volume in declining issues and is negative. The Arms Index, therefore is a contrary indicator that trends in the opposite direction of the market.  It can be used for intraday trading by tracking its direction and for spotting signs of short term market extremes.
Smoothing the Arms Index
While the Arms Index is quoted throughout the trading day and has some short term forecasting value, most traders use a 10 day moving average of its values. According to Arms himself, a 10 day average of the Arms Index above 1.2 is considered oversold, while a 10 day Arms value below .7 is overbought, although those numbers may shift depending on the overall trend of the market. He suggests using a 21 say Arms Index in addition to the 10 day version. He also uses 21 day and 55 day moving-average crossovers of the Arms Index to generate good intermediate term trades.

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