A New Advance-Decline Line by Daniel E. Downing
Here's a trading tool that uses a unique version of the daily advance-decline line of the New York Stock Exchange (NYSE). This version helps in our short- and long-term trading of index options and stock index futures. It gives many good short-term trading signals and excellent but infrequent longer-term signals. As with all technical tools we develop, two factors are most important. First, the tool must be easy to construct and maintain, and second, the tool must use as few layers of analysis as possible, not layer upon layer of if-then conditions. We construct technical tools to assist the technician's intuition.
The philosophy behind this tool is that the short-term trader's capital is finite and that traders have to reliquefy their holdings after a period. Traders can buy and try to push the equities higher only so many times before they need to reliquefy, just as only a finite amount of selling waves can take place before the sellers are out of supplies. A tool that points to when short-term traders need to reliquefy their positions will also spot when the markets will soon reverse their trends.
When we speak of reliquefying, we refer to the longs in the market cashing in positions by selling and the sellers in the market either running out of stocks to sell or covering their shorts. In such a situation, the longs have used up their cash in buying stocks; stocks are no longer at a level where the short-term traders wish to purchase, or they want to take some profits on their longs. The sellers wish to take profits on their shorts, have no more stock to sell or feel that stocks have fallen to levels where the sellers no longer wish to sell.
The new advance-decline line that we have devised identifies these points with a simple line chart and basic chart analysis. Breakouts and breakdowns on the chart from congestion patterns (that is, sideways trading) as well as chart formations (double and triple bottoms, trendlines, rising bottoms and so forth) point to changes in the supply and demand picture of short-term equity traders. The line graphically shows when traders are running out of steam or gaining strength. The changes in the special advance-decline line lead to price changes in the Standard & Poor's 500 cash index.