Have you ever heard of Market Breath? In this article, you’ll learn all about the primary Market Breath indicator, which is the Advance-Decline Line (ADL). The main bibliographical references for this lesson are two books. The first is by Marcio Noronha, the father of technical analysis in Brazil, who states that this is “the simplest and most important tool in this book.” Chapter 4, page 103.
The other book is “Technical Analysis Explained” by Martin Pring, Chapter 27 – Market Breath, page 560. I’ll show you how to use the ADL, which is this line below. But first, let’s understand all the concepts behind it.
What is Market Breath?
First, what is market breath? Well, I could answer that it’s a way to determine if the Bovespa Index is misleading and the Brazilian Stock Exchange is actually declining. But to be more technical, market breath is a way to analyze the performance of a group of stocks against an index of which they are a part. Ah, so this indicator is only useful for trading stocks?
No, everything you’ll learn here can be applied to any market, but market breath indicators were originally developed to monitor trends in the stock market.
The ADL Provides More Insight than the IBOV
Returning to the issue of market breath, to make it easier to understand: If I ask you if the stock market went up today, you’ll probably look at the Bovespa Index, and if it’s green, you’ll say, “Yes, it went up.” Then I’ll look at you and say, “Actually, the market went down.”
Most stocks depreciated today, but the banking sector surged, and the Bovespa Index uses a weighted average, giving more weight to highly liquid stocks. This creates the illusion that the stock market rose.
But you, being smart, plotted the Advance-Decline Line (ADL) on the Bovespa chart, and it was this indicator that made you realize that most stocks did not follow the Bovespa Index’s rise.
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Let’s summarize everything here so nobody gets lost. {note}
Advance-Decline Lines
The Advance-Decline Line is the primary market breath indicator, created by Joseph Granville (OBV).
All stocks included in its calculation have the same weight, which I explained earlier: the Bovespa Index calculation gives more weight to highly liquid stocks, but the ADL indicator does not have this weighting. It’s concerned with whether most stocks are rising or falling. Alright. And the ADL is constructed from cumulative data on the difference between the number of stocks rising and falling over a given period.
Which stock exchange? Any of them, I can see the ADL for the IBOV, Nasdaq, DAX in Germany. This indicator will alert you if the index is misleading, the market has turned, the stock exchange has peaked, and most of the stocks are falling while you’re buying at the top because your vision was obscured by the index calculation, which gives more weight to highly liquid stocks.
So, you’re seeing some sectors of the economy rising but considering that this applies to the entire market. So, here’s an interesting perspective: your view was obscured; this is not the most accurate picture of the market.
Divergences and Market Tops/Bottoms
Those who understand technical analysis have already figured out how to use this indicator with just this preliminary information; I didn’t even need to explain. Before explaining, I want to remind you that this channel is a partner of BTG Pactual, the brokerage for day trading or long-term investing. I use and recommend BTG Pactual; I’ll leave the link for you to open your account in the description below.
Let’s add here: Positive divergences occur at market bottoms where the ADL does not confirm a new low.
In other words, prices are forming lower lows, but the indicator does not form a lower low, it’s a positive divergence, also called bullish divergence, implying that the current downtrend is technically weak, as the greater the number of divergences, the greater the technical weakness of this market.
Negative divergence is the opposite, prices in an uptrend but the Advance-Decline Line does not confirm a new high.
Comparing to Other Indices
So here’s the deal, this indicator will rise along with the main market indices, but usually it peaks before the indices, indicating that the stock exchange has already peaked and will decline. The chartist’s gaze is always seeking divergences in the ADL compared to the price. In fact, Martin Pring says that the ADL is a better gauge of the market than a Blue Chip index.
In other words, instead of looking at Petrobras, Vale, Ambev to draw a conclusion about the trend of the Brazilian stock exchange, you can put an ADL on the chart, see if it’s in line with the current trend or if there’s a divergence. Here, I have the IBOV open on the daily chart, indicators, Advance-Decline Line.
Instead of simply looking at the main indices to see if the stock exchange is doing well or poorly, in an uptrend or downtrend, put an ADL on the chart and compare because if the line is not in line with the price, it’s a warning sign of a market turnaround.
In this book by Marcio, he mentions Joseph Granville, the creator of this indicator, who explained the theory of the Advance-Decline Line through a bathtub analogy. {paragraph 2 page 104}
Watch the video about the ADL:
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