Advancers! Decliners! Why Traders Learn to Bet on Market Breadth

One of my earliest memories about the stock market was seeing the late Louis Rukeyser talk about "advancing issues" and "declining issues" during his television program, Wall $treet Week with Louis Rukeyser, back in the 1970s.

The relationship between advancing issues -- stocks that are moving higher on the day -- and declining issues -- stocks that are moving lower on the day -- is summed up in the term, market breadth. Market breadth gives traders a stronger sense of how many stocks are participating when the market as a whole is moving upward or downward.

Market breadth is said to be poor or weak when there are more declining stocks than advancing stocks. On the other hand, market breadth is said to be good or strong when there are more advancing stocks than declining stocks.

One thing that traders do when they look at market breadth is to compare the breadth of the market with the type of close the market has on a given day. If the market closes up, but breadth is poor, then a trader may become suspicious of a rally and choose to wait for further confirmation that a market is indeed able to continue moving higher. If the market closes down, but breadth is strong with more advancing stocks than declining stocks overall, then a trader may believe that the market's move down may not be as scary and severe as it may seem.

There are a number of ways that market breadth information can be presented. The most common fashion, in the financial media, for example, is simply to refer to the number of "advancers versus decliners." The comparison between advancing stocks and declining stocks can also be expressed as a ratio, often referred to as the advance/decline ratio or A/D ratio. A third way is simply to subtract the number of declining issues from advancing issues to create a value that can be positive (with more advancing issues than declining issues) or negative (with more declining issues than advancing issues).

Market breadth can be a powerful tool for traders reviewing the previous trading session, looking to determine whether or not a market's move higher -- or lower -- is to be taken at face value. But market breadth is also a powerful tool for traders analyzing the market on an intraday basis. Often, the relationship between advancing stocks and declining stocks will begin to change over the course of the market day. This can allow observant traders to spot potential market bottoms, tops, reversals or breakouts before they happen, and take intraday positions that will allow them to exploit the subsequent market move.

Consider this example from the market bottom in 2003. The S&P 500 is in the upper pane and one breadth measurement indicator, the advance/decline line is in the lower pane. Notice when the advance/decline line bottoms in this weekly chart. In early February. However the S&P 500 continued lower for a full month before bottoming, turning around and heading higher itself. The change in relationship between advancing issues and declining issues anticipated the change in the broader market.

Another interesting example comes from the market rally into the 2007 top. For a year from the summer of 2005 through the summer of 2006, the breadth indicator -- the advance/decline line -- rose in tandem with the S&P 500. And when stocks dipped in the summer of 2006, the breadth indicator dipped, as well. But even though the market turned around after a few months and resumed moving higher, the advance/decline line did not follow suit and, instead continued moving lower.

This weak breadth as the market moved higher from the second half of 2006 into 2007 was a warning, as we know now, that the rally higher was not as self-sustaining as it may have appeared. 2007 was the year of the sharp corrections, as those divergences between the S&P 500 and the breadth indicator came home to roost in March, August and throughout the entire fourth quarter.

David Penn is Senior Editor at TradingMarkets.com