Stock Market Indicators
This page is designed as a tool to help my readers understand the various stock market indicators or jargon that I commonly use in my writing – but at the same time, it also serves to remind me the significance of each indicator given certain fundamental and technical situations in the stock market. It is probably a true statement to say that the majority of investors or traders who apply some of these indicators in their everyday analysis of the stock market do not exactly know (or remember) what they are or truly understand how they should be applied (the author has been guilty of this in the past as well). Hopefully, the following will clear things up.
Note: One of the pitfalls of the novice investor/trader has always been this: In “discovering” a technical indicator that has been successfully applied in the past to time the market or an individual stock, the novice investor sometimes relies too much on this indicator. Keep in mind that no indicator out there is infallible – and therefore none of these indicators should be used alone but in conjunction with other studies.
The Advance/Decline has been one of the most popular tools in measuring the breadth of the broad market. It is a cumulative sum of the daily differences between the number of stocks advancing and the number of stocks declining. Plotting this indicator on an intermediate term or long term basis is a great way to gauge the strength of the broad market. Traders believe that cap-weighted indices such as the NASDAQ Composite or the S&P 500 cannot have a sustained advance if they rise without the A/D line confirming (commonly called a “divergence”). There have been various times in history when the A/D line has acted as a precursor of a significant stock market top – the most recent being a topping out of the NYSE A/D line in April 1998 – nearly a whole two years before a corresponding top in the major indices such as the DJIA, the NASDAQ Composite, and the S&P 500.
ARMS Index (or TRIN)
Developed by Richard Arms in 1967 and first introduced by Barron’s in the same year. One of the first to adopt this indicator in his market analysis was Richard Russell, the last living Dow Theorist and writer of the Dow Theory Letters. The ARMS Index is a market breadth and strength indicator, which attempts to analyze the relationship between the number of advancing and declining issues and the advancing and declining volume. The ARMS Index is calculated by the following formula:
(Number of Advances / Number of Decliners) / (Advancing Volume / Declining Volume)
An ARMS Index reading of one means that the market is in balance, while a reading above one means more volume is moving into declining stocks (bearish) and vice versa. The ARMS Index can also be used as an oversold/overbought indicator when smoothed by a simple moving average – such as using a 10-day or a 21-day moving average.
Daily High-Low Differential Ratio
The Daily High-Low Differential Ratio is a momentum/overbought-oversold indicator that this is predominantly used by the editor of this website and has historically been a very reliable technical indicator. The Daily High-Low Differential is calculated by taking the difference between the daily number of new 52-week highs and the daily number of new 52-week lows and dividing the result by the total number of issues (in either the NYSE or Nasdaq Composite) traded during that day. The formula is as follows:
Daily High-Low Differential Ratio = (Number of New 52-week Highs – Number of New 52-week Lows) / Total Number of Issues Traded During the Day
Because of the fact that more than 50% of all issues on the NYSE today are preferred stocks, close-end funds, or foreign ADRs, the author typically only tracks this ratio on the Nasdaq Composite since the latter mostly consists of domestic, common stocks. In a cyclical bull market, a highly oversold situation usually occurs when the Nasdaq daily high-low differential ratio reaches the (8%) to (14%) level. A reading of 10% is typically indicative of a highly overbought situation. Extremely oversold readings have gotten to be as low as (20%), but this has only happened in two instances over the last 25 years – once during the October 1987 crash and the other instance during the Russia/LTCM crises in October 1998. Please note that computing this indicator as a ratio is highly important since this allows readings to be compared over time as the number of issues traded in the United States has fluctuated greatly over the years.
The formula for the McClellan Oscillator is:
10% Trend – 5% Trend, where
the 10% Trend = the exponential moving average (EMA) of the daily number of advancers minus number of decliners with a 10% smoothing constant (or the 19-day EMA), and;
the 5% Trend = the EMA of the daily number of advancers minus number of decliners with a 10% smoothing constant (or the 39-day EMA).
Most traders use the McClellan Oscillator for two types of interpretations. Firstly, when the McClellan Oscillator is positive then it means there is new money coming into the market – with the magnitude of the McClellan Oscillator determines the amount of money coming into or leaving the market. Secondly, when the McClellan Oscillator is in extreme territory, it can be used to indicate an overbought or oversold situation.
McClellan Summation Index
The level of the McClellan Summation Index is obtained by summing up the daily values of the McClellan Oscillator. A market is termed “neutral” at the +1000 level; during a normal bull market, the Summation Index usually swings in between a range of 0 and + 2000. The significance of the Summation Index comes into play when the reading is outside the range of 0 and + 2000 – indicating an unusual situation in the stock market. For example, a bear market typically end with the Summation Index below - 1200. Long-term investors can typically buy stocks at such a level and expect to make outsized returns over the long-run. A strong rise from such an oversold level would further confirm the beginning of a new bull market.
Percentage Price Oscillator (PPO)
The PPO is obtained by subtracting the longer-term moving average of prices from the short-term moving average and then dividing the result by the longer-term moving average. Stockcharts.com uses a 6-week exponential moving average for the shorter-term and a 12-week exponential moving average for the longer-term average (a 12-day and a 26-day on the daily charts). Momentum is deemed to be positive while the shorter-term is above the longer-term average (or negative when vice-versa), but the PPO can also be used as an overbought or oversold indicator. The weekly formula is as follows:
(6-week EMA – 12-week EMA) / 12-week EMA
The VIX is derived from the prices of ALL near-term at-the-money call and out-of-the-money call and put options traded on the S&P 500. Options that are in the money are not included. The VIX is a measure of fear and optimism among option writers and buyers. When a large number of traders become fearful (when they want to buy a large number of put options, say, to hedge their long positions in stocks) then the VIX rises. Conversely, when complacency reigns, the VIX falls. The VIX is sometimes used as a contrarian indicator (especially at extremes) and therefore can be used as a measurement of how oversold or overbought the market is. During the bear market of 2000 to late 2002, a VIX reading of 20 is usually an indication of an overbought market, while a reading of over 40 is usually an indication of an oversold market. In recent months, however, the VIX has been consistently under 20 (similar to market conditions during the period 1991 to 1996) – so raw VIX readings are sometimes of limited value, unless you combine the VIX readings with some kind of overlay or other technical analysis studies.