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Putting the Advance/Decline Line in Perspective

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As the open approached on October 7, 2008, futures stayed above fair values. Even before the open, I had worried about a pop-and-drop type day, as noted in my 9:27 am post on the Market Monitor, the live portion of the Option Investor site. When the advance/decline (A/D) line made its first prints, however, I had even more reason to be worried. "The A/D line went into breakout mode first thing," I wrote in my 9:40 post, "which is always a bit iffy of a setup."

What made the setup "iffy"? The A/D line's first print was +856. Within the first few minutes after the cash markets opened, the A/D line had reached +1218. That means that there were 1218 more advancing stocks than declining ones on the NYSE. What's iffy about that? Sounds good, doesn't it?

Not necessarily.

In forming my own market outlook, I find it's important to put the A/D line in perspective. I've mentioned the way I use the A/D line in previous Trader's Corner articles, but I find that perspective even more important in the current market environment. We need all the help we can get these days.

Here's what I was seeing the morning of October 7:

Unfortunately, those annotations needed editing, but my charts carry back only 10 days, so I can't edit the last sentence. It should have read, "This one was, as was the similar breakout on Thursday, 10/9."

I have several reasons for my preference in using Keltner channels or bands to gain that perspective on the A/D line. I'll explain those reasons, but then show what you can do if you're not interested in Keltner channels or bands, don't understand them, or can't set them up on your charting platform.

I can base several different Keltner channels or bands on different moving averages. The settings I use are the same that I use for equities. On a 15-minute chart, I base one channel on a 9-ema, with the bands having an offset (called "multiplier" on Q-Charts) of 1.4; one channel on a 45-ema with an offset of 3 and one on a 120-ema with an offset of 7.2. It's the outer channel that gives me the most information about strongest support or resistance or breakout moves with the A/D line, but I use all the lines.

When the channel lines or midlines converge, I can make judgments about the strength of support versus resistance and set possible targets. For example, when the A/D line was at +957 on the morning of 10/9, I wrote in a 9:39 Market Monitor post that the A/D line was vulnerable to "the possibility of a strong pullback, perhaps to +400 historical [support] or to -128 to -245 potential Keltner support." That Keltner support was the then-current level of the black-channel support, the channel or band based on the 45-ema. I thought it possible that the A/D line could drop rather quickly to that level.

It was to drop further, and I was to update at 10:58 that the A/D line was "vulnerable to a drop to near -1250." I added that "I would, however, watch for a potential steadying anywhere from its current -996 level down to about -1250."

That steadying did occur until late afternoon. The support then caved, something that was as visible on the A/D line as it was on equities. These and other reasons result in my preference for these layered Keltner channels, but I've heard from plenty of subscribers who can't employ these channels. They, too, can find perspective.

Fifteen-Minute Chart of the A/D Line with Bollinger Bands:

I'm not as accustomed to watching the A/D line on Bollinger bands, so I can't verify that the BB's work as well as the Keltner channels to identify breakouts. Nor can I tell you that this setting is the optimum one. The purpose of the article is to suggest that you refer to your own preference for determining overdone status and learn the ins and outs of how your preferred indicator works in relationship to the A/D line.

What you're trying to do is get some perspective on the A/D line. My Keltner channels might tell me one day that a -1000 A/D line is actually a rather neutral reading, while a week later, a -1000 might be overdone to the downside.

As with any indicator, this shouldn't be used as a trade setup but rather as a warning to update your profit-protecting plans if you've been trading in the direction of the A/D line's breakout. Such breakouts, particularly first thing in the morning and last thing in the evening, particularly when verified by an RSI at extreme levels, can alert traders of the possibility of a reversal.

They do not prove a reversal will occur. They're indicative of strong momentum and sometimes that strong momentum carries through all day with the breakout maintained all day, at least on Keltner channels. Wouldn't it have been worth some money, however, to have been alerted the mornings of 10/7 and 10/9 to be careful with bullish trades and to prepare what-if plans in case of a reversal? I think it was worth some effort to get some perspective on the A/D line. Maybe you will, too, by whatever method you use to obtain that perspective.
 

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