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Not an Odd Couple at All

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Let's set the stage. It's early Thursday, February 21 and the weekly jobless claims showed a week-over-week drop of 9,000. At least that's what the headlines on financial newswires said. The supposed drop was actually from a revised-higher figure from the previous week.

That doesn't matter. What matters is that traders were cheered by the lower jobless claims. Futures were higher. All was right in the financial world.

When the cash markets opened, the SPX gapped higher and ran right up into the 1367-1370 resistance. The climb was corroborated by a soaring advance/decline line. All was still right in the equities world.

Not quite all, though. Even ahead of the 10:00 am ET release of the February Philadelphia Fed Business Index, something in the climbing advance/decline line signaled potential trouble ahead.

What was that signal? It was found when viewing the advance/decline line charted on a graph with Keltner channels. For clarity, the chart below includes only one set of the three nested Keltner channels that I typically watch.

Annotated 15-Minute Chart of the Adv/Dec Line:

The way the advance/decline line looked on this chart told me that although the day opened with a strong advance/decline line, that strength didn't tell the whole story. The advance/decline line was about to slam into potentially strong resistance. Although in this case, historical resistance corroborated that impression, that historical support and/or resistance is not always present. Sometimes only the Keltner channels show the approaching support and/or resistance.

That resistance did hold. Most attributed the pullback that began about 30 minutes after the open that day to the release of the Philly Fed number, but I propose that the advance/decline line was already showing some possibility of a pop-and-drop day. The Philly Fed was only the catalyst for what was already setting up on the charts.

By late morning that day, the SPX had stabilized after an early decline and was bouncing, but the advance/decline was already signaling more trouble ahead, as my 11:26 post on the live portion of our site indicated. The advance/decline line had fallen beneath the central basis line of the Keltner channel shown here. My post alerted subscribers on the live portion of the site that I thought the advance/decline line was going to rise up to retest that broken support, perhaps bringing the SPX up with it, but then that the advance/decline line was likely to roll down. It did roll down, and so did the SPX.

Annotated 15-Minute Chart of the SPX:

Some of you might be thinking that it's easy to pick some instance that showed what I want it to show, but those who have read my commentary on the live portion of the site know that February 21 didn't comprise an isolated instance.

Several questions arise as a result of these two charts and the anecdotal information: What is the advance/decline line; is it amenable to technical analysis; and, if it is, how can it be used with Keltner channels? A single article can't address all those questions, but let's start with what the advance/decline is and whether it's amendable to technical analysis.

Investopedia.com defines the advance/decline (AD) line as the "(# of Advancing Stocks - # of Declining Stocks) + Previous Period's A/D Line Value." Some feed sources provide an advance/decline for both the NYSE-listed and Nasdaq-listed stocks. A moving average of the advance/decline is sometimes used to smooth the fluctuations.

Some sources calculate the advance/decline differently. They calculate a ratio. I, like some other technical analysts, prefer the ratio form, but my current feed source does not provide a ratio.

Why would a ratio be better? Consider what happens during the lunchtime lull on a strong rally day, for example. The advance/decline line might have been soaring, but then traders head off for lunch and volume dries up. When everyone trots off for lunch, it's possible to imagine that the advance/decline line calculated by the subtraction method might drop just because there are fewer traders around and fewer stocks being traded.

However, the same distortions don't exist for the ratio variation. Unless disproportionate amounts of buyers and sellers head off to lunch, something that's difficult to imagine happening with regularity, the ratio should not be impacted by a drop in volume during the lunchtime lull. Any drop in the ratio form of the advance/decline line should reflect a change in the proportionate amount of advancing and declining stocks.

Whatever form of advance/decline line feed services provide or traders follow, an advance/decline line offers a view of what's happening in the markets that is independent of price. Many other indicators are derived from a study of the prices. For example, calculating the stochastic indicator requires the following inputs: the closing price, the lowest low over the desired period of time, and the highest high over that same period of time. While I believe that the stochastic indicator can be a useful indicator, it's not independent of price action.

However, the advance/decline line is independent of price action. Traders trading a downtrend in prices want to see that independent source corroborate their trades. If they're trading a rally, they want to see the advance/decline line climbing. If they're trading a downtrend, they want to see the advance/decline line dropping.

New traders might be surprised to note that it doesn't always happen that way. Prices can head higher while the advance/decline line heads lower, no matter which variation of the advance/decline line is employed.

For example, imagine that prices are going higher, but beneath the markets, traders are actually worried, with many buyers standing back. A few issues, maybe some of the big caps, are performing well enough, as they often do in a defensive market, but worried traders are beginning to step out of some of their long positions.

An experienced trader might glance at the advance/decline line while the stocks are still climbing and note that the advance/decline line is headed lower. There's a divergence. Divergences are important in many types of indicators, even in those such as the stochastic indicator that is derived from price. Perhaps they've even more important when seen on an independent indicator, signaling that prices might be nearing a reversal. Many experienced traders believe that volume patterns sometimes lead price patterns, and I'm one of them.

I believe it so strongly that I not only want to see those times when divergences already exist: I want to see times when the advance/decline line might be about to reverse. If that advance/decline leads price, as I believe it can do, then I want to know when it's about to lead the opposite direction.

How does one determine that? I use the same technical analysis tools I use when looking at price charts. Some market participants feel that such tools are useless when applied to the advance/decline line, the VIX and other beneath-the-markets measurements, but I believe that most can be studied using standard technical analysis tool.

The TRIN can be an exception. While I sometimes find that the TRIN reverses exactly where my chart setups would suggest it should, I haven't always been able to find much useful information about the TRIN using those standard technical analysis tools.

Unlike the TRIN, studying the advance/decline with standard technical analysis tools was so helpful that for a while I experimented with entering and exiting scalps or day trades based only one what I was seeing on the advance/decline line. The number of profitable versus losing trades was phenomenal, but when entering based on the advance/decline line, setting account-appropriate stops was difficult. The advance/decline line was great at predicting when a profitable trade should be exited, but in the case of a trade going wrong, the advance/decline setup let the price loss get too big in some instances. Too many small profits were wiped out by one bigger loss. As you can imagine, that situation doesn't prove profitable in the long run, but that doesn't mean that studying the advance/decline line isn't helpful. Just don't let it be your only guide to entering and exiting trades.

Here's another instance when standard technical analysis tools, simple trendlines in this case, proved helpful in predicting when the advance/decline line might reverse.

Annotated 15-Minute Chart of the Advance/Decline Line:

The first chart in this article had predicted horizontal trendline resistance, too, but trendlines may not be as common on the advance/decline line as on price charts.

My preferred method of finding likely reversal spots and making if/then kinds of predictions about the advance/decline line is by following it on a chart with Keltner channels. Subsequent articles in this series will talk about how I use Keltner channels in this manner, setting likely upside or downside targets for the advance/decline line.

Before you read those articles, spend some time this week using your own preferred methods of technical analysis, deciding whether you agree with the premise that the advance/decline can be followed by using standard technical analysis tools.

Don't try trading based on what you're seeing but do notice any divergences that might show up, any trendlines, or any responsiveness to RSI values above 70 or below 30. You'll have to check your charting service's symbology for the advance/decline line if you're not used to watching it. The symbols can be different to ascertain logically. For example, my charting service uses JINT.Z for some reason.
 

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