Breadth of Market Theory

What Is Breadth of Market Theory?

The breadth of market theory is a technical analysis methodology that measures the strength of the market according to the number of stocks that advance or decline in a particular trading day, or how much upside volume there is relative to downside volume.

The breadth of market theory is the basis for the breadth of market indicator.

Understanding Breadth of Market Theory

There are multiple ways to analyze market breadth, which is a measure of the robustness of the stock market as a whole. The overall robustness of the stock market may not be evident by only looking at major market indexes such as the S&P 500, Nasdaq 100, or Dow Jones Industrial since these indexes only hold a select group of stocks.

Breadth is typically a measure of how many stocks are advancing relative to the number declining. Alternatively, it may also include volume studies, such as volume in rising stocks versus volume in falling stocks.

Advance/decline indicators measure the number of stocks advancing and declining for the day. If the breadth indicator is rising over time, this indicates the market is strong and the rise in the index is sustainable. For example, if a market is comprised of 150 stocks and 95 stocks experience price gains while 55 stocks either experience no change or decline in price, according to the breadth of market theory, the market is currently considered strong or rising.

If the advance/decline falls while major stock indexes rise, this indicates that fewer stocks are participating in the rally and could forewarn of a fall in the indexes. As fewer and fewer stocks rise, the index's performance will eventually begin to suffer as well.

Breadth indicators are not accurate timing signals. While they may warn of a decline, they don't indicate when it will happen. Similarly, a rise in the breadth indicator while the major indexes are declining warns that buying pressure is building and the indexes may start to rise soon, but it doesn't tell us when.

Special Considerations

Breadth indicators often act in tandem with the price moves in indexes. For example, a rise in the index sees a rise in the breadth indicator. This is called confirmation. When the breadth indicator diverges it warns of a potential change in the index direction. Changes in index direction are not always forewarned by the breadth indicators.

Market breadth looks at how many stocks are advancing and declining (and volume) to determine how strong the stock market is. Dow Theory also looks at the robustness of the market but uses different tools. One of the tenets of Dow Theory, and there are several, is that industrial and transportation indexes should confirm each other. When the two are moving in different directions it could signal trouble.

Popular Breadth of Market Indicators

Two popular market breadth methods include the Advance/Decline ratio (ADR) and the Advance/Decline line (A/D line).

The ADR compares the number of stocks that closed higher against the number of stocks that closed lower than their previous day's closing prices. To calculate the advance/decline ratio, the number of advancing stocks is divided by the number of declining stocks. The advance/decline ratio is typically calculated daily.

The A/D line plots changes in advances and declines on a daily basis and the result is cumulative. Each data point is calculated by taking the difference between the number of advancing and declining issues and adding the result to the previous period's value, as shown by the following formula:

A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Previous Period's A/D Line Value

Shorter-term breadth indicators include the tick index and the Arms index (TRIN). The tick index compares the number of stocks making an uptick versus a downtick. This is an intraday indicator. The Arms index compares the advance/decline ratio to advancing/declining volume.

Other breadth indicators include On Balance Volume (OBV), Up/Down Volume Ratio, and the McClennan Summation Index.

Breadth of Market Theory Example

The S&P 500 could be compared with the NYSE A/D line to monitor underlying strength or weakness. The NYSE A/D line is looking at all stocks listed on the NYSE, while the S&P 500 is only tracking a select group of 500 stocks. The NYSE A/D line provides a broader measure of how most stocks are doing.

The chart below shows the SPDR S&P 500 ETF (SPY) along with the NYSE A/D line. In early 2018 the S&P 500 was moving lower, but in April the NYSE A/D line was making new highs. The S&P 500 was nowhere near its highs, yet ultimately the index followed suit and made new highs like the A/D line.

Image by Sabrina Jiang © Investopedia 2021

Once again, in early and mid-2019, the NYSE A/D line moved above prior highs in advance of SPY moving above corresponding highs. The S&P 500 followed suit and eclipsed the prior highs.

Breadth of Market Theory Limitations

Breadth of market theory is looking at historical data. Like any data, new data could come in to invalidate the old. For instance, a trader may exit long positions as the index goes up but breadth indicators decline. The index may keep going up, and the breadth indicators may start going up as well to confirm.

Breadth indicators are not timing signals. While they provide beneficial information about the state of the market, they don't signal when it will decline. For that, traders need to watch price action. Breadth indicators can provide forewarning, but price action will provide the actual trade signals.

Breadth indicators are best used in conjunction with price action, and other forms of analysis, to determine buy and sell signals.

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