The advance/decline ratio is a popular and common metric that traders and financial managers alike use to gauge market sentiment. The ratio simply gives an indication of the number of stocks that gained in value relative to the number of stocks that lost value over a given time period. While the advance/decline ratio is rarely used on its own, it can be a useful metric for identifying overbought or oversold conditions or spotting market trends.
What Is The Advance/Decline Ratio?
The advance/decline ratio is a measure of how many stocks gained value in a given time period versus how many stocks lost value in that same time period. For example, on a daily basis, the advance/decline ratio measures how many stocks closed higher today than yesterday versus how many closed lower today than yesterday. So, the advance/decline ratio will be high when the market exhibits a broad bullish movement and less than one when it exhibits a broad bearish movement.
The advance/decline ratio is frequently cited as a metric for the stock market’s performance on any given day. However, the ratio can also be calculated over longer time periods, such as weekly or monthly. It’s worth noting that the advance/decline ratio is typically calculated by looking at all of the stocks traded on the New York Stock Exchange. But, it could also be calculated for a specific index or even a specific market sector.
How Can You Use The Advance/Decline Ratio?
The advance/decline ratio will not usually form the basis of a trading strategy on its own. But, the metric can provide some insight into market trends that in turn may influence trading strategy.
Breadth Of A Market Move
One particularly useful way to put the advance/decline ratio to work is to use it as an indicator of how broad a specific bullish or bearish movement is within the overall market. Since the S&P 500 is weighted by market cap, a 5% gain in the index can either come about because of huge moves by a few mega-cap stocks or because of smaller bullish moves by hundreds of stocks in the index. Although unlikely, it’s possible that the S&P500 could increase by 5% even if the majority of stocks in the index actually lost value on the day.
The advance/decline ratio can quickly give an indication of which scenario caused such a movement in an index like the S&P 500. The higher the advance/decline ratio, the broader the bullish movement was across all stocks being measured in the calculation. This is helpful since it allows traders to look beyond what index percentage gains or losses typically reveal to understand how broad or sharp a day’s price movement really is.
Overbought vs. Oversold Conditions
Another potential use of the advance/decline ratio is as an indicator of overbought or oversold conditions. When the number of advancing stocks far outnumbers the number of declining stocks – that is, the advance/decline ratio is unusually high – it may indicate that, at least in the short term, stocks are generally overbought. On the other hand, if the advance/decline ratio is unusually low, stocks may be oversold across the market.
Of course, evaluating overbought and oversold conditions does require additional technical analysis. Not every stock will be overbought or oversold, no matter what level the advance/decline ratio is at. However, monitoring the advance/decline ratio for sudden spikes can help traders identify times when there are potentially more buying or selling opportunities across the stock market.
Bullish vs. Bearish Trends
By tracking the advance/decline ratio over time, it’s also possible to identify bullish and bearish trends in the market. In a bullish trend, the advance/decline ratio will consistently be greater than one – meaning that more stocks are gaining than losing over a period of multiple trading days in a row. In a bearish trend, the advance/decline ratio will be less than one.
Conclusion: The Advance/Decline Ratio
The advance/decline ratio is a simple and easy-to-understand indicator of how stocks across the stock market are performing on a given day. The ratio allows traders to look past the performance of major indices like the S&P 500 to get a sense of whether that performance is driven by a small number of mega-cap stocks or by the majority of stocks in the index. On top of that, the advance/decline ratio can be a helpful tool for identifying overbought and oversold conditions or bullish and bearish market trends.