Two market breadth indicators (an update)

Six weeks have elapsed since my previous post on two Nifty breadth indicators - the A-D line and the TRIN. During this period, the Nifty consolidated in a rectangular range between 4700 and 5200, just below the large descending triangle pattern it had formed since the top of Nov '10. Here is a quick update on the two market breadth indicators.

Nifty A-D Line


The A-D line has tracked the Nifty's fall since the Nov '10 peak with some notable exceptions. During Feb '11 to Apr '11, the Nifty made a series of three higher bottoms, while the A-D line reached three lower bottoms. In the rally that followed, the Nifty reached a higher top in Apr '11 than the top in Feb '11. But the A-D line's Apr '11 top was at the same level as its Feb '11 top. These negative divergences were a warning that the next down leg in the Nifty was imminent.

Again, the Jun '11 bottom on the Nifty was at the same level as the second bottom in Feb '11. But the A-D line touched a much lower bottom in Jun '11 - a negative divergence that suggested that the subsequent rally may be short-lived. What the A-D line does not indicate is exactly when the negative (or positive) divergences will affect Nifty's movements.

Last week, the Nifty made a higher bottom within the trading range, but the A-D line touched a slightly lower bottom. The negative divergence is a likely precursor to more selling in the coming week.

Nifty TRIN


 There are a couple of interesting points to note on the Nifty TRIN chart. In end-Aug '11, when the Nifty fell to its 52 week low after breaking down below the descending triangle pattern, the TRIN spiked to 1.25. A value of 1.2 or higher means the market is oversold and due for a rally.

The rally followed almost immediately, but the Nifty quickly reached an overbought condition - as indicated by the sharp drop of the TRIN below 0.75. A correction in the Nifty followed, but the TRIN is not indicating an oversold condition as yet. We can, therefore, conclude that the correction in the Nifty isn't over yet.

Both the A-D line and the TRIN are pointing to a further correction in the Nifty. Any upward bounces are likely to attract selling. As with all technical indicators, these two are not fool-proof and should be used in conjunction with other indicators like EMA crossovers, slow stochastic, ROC, RSI.

(Charts from: www.icharts.in)

Two market breadth indicators

The Advance-Decline (A-D) line (or ratio) is an important technical indicator used to measure market breadth. I had covered the indicator in a post on Mar 23, ‘10 – but wasn’t able to provide a practical example. I propose to ‘fill the gap’. The TRIN (Short-term Trading Index) will also be covered in this post.

The Sensex and Nifty are in firm bear grips with no end to their corrections in sight. The two indices comprise 30 and 50 shares respectively, and are supposed to be representative samples of the entire stock market. Are they?

Thousands of shares are traded at the BSE and NSE every day. Isn’t it possible that the two indices may not be revealing the true picture? Well, mostly they do – however strange it may seem. But there are occasions when the indices may be moving up when the broader markets are heading down, and vice versa.

These are the ‘divergences’ that are of interest to the astute investor. Contrary behaviour can point to likely reversals in the prevailing trend. Market breadth indicators like the A-D Line and TRIN can be of some help in spotting likely reversals. As with any technical indicators, they are not fool-proof. Use them in conjunction with other indicators.

Nifty A-D Line

Note the period between Sep ‘10 to Nov ‘10 (left-most portion of above chart). The Nifty kept rising and reached a new high, while the A-D line was falling. This negative divergence indicated in advance that a correction was likely to follow. What it didn’t indicate was when the correction was going to begin, and how long it was going to last.

Since the Nov ‘10 top on the Nifty chart, the A-D Line has mostly tracked the Nifty’s fall – as it is supposed to do. A couple of interesting negative divergences occurred in Feb ‘11 and Jun ‘11. The Nifty made two bottoms in Feb ‘11 – the second one slightly higher than the first. But the A-D Line touched a lower bottom. Again in Jun ‘11, the Nifty fall stopped at the level of the second (higher) Feb ‘11 bottom, but the A-D line fell to a new lower bottom. The divergences indicated that the subsequent rallies (in Apr ‘11 and Jul ‘11) will be short-lived.

Now, both the Nifty and its A-D Line are falling together and touching new lows. One can look for the A-D line making a higher bottom while the Nifty falls lower. That would be a positive divergence indicating a possible change of trend. But the A-D Line is better at signalling a market top than a market bottom. So, both may start rising together, without giving any advance signal of a trend change.

Nifty TRIN

The TRIN measures the amount of buying and selling pressure in the market. The formula is:

The TRIN can also be used as an overbought/oversold indicator by using its 10 day Moving Average, as has been done in the chart above. A 10 day moving average value of 0.75 or below means the market is in overbought zone, and ready for a correction (note the period between Sep ‘10 and Nov ‘10). A value of 1.2 or higher indicates the market is oversold, and ready for a rally (like in Feb ‘11).

In spite of the Nifty touching a new 52 week low on Fri. Aug 19 ‘11, the 10 day moving average value of TRIN is below 1.0 – not quite in oversold zone yet. Any bounce up from current level is likely to attract selling pressure.

(Note: Charts from www.icharts.in)

Should investors join the ‘Bollinger Bands’ wagon?

Bollinger Bands are a technical analysis tool, developed about 30 years ago by John Bollinger. Before we get into the nitty-gritty of what these bands are and why investors might find them to be a useful tool, a few words about a statistical concept called ‘standard deviation’.

Standard deviation, in layman’s language, means the amount by which a series of measurements vary from the average value of the measurements. Let us say, we are measuring each day’s maximum temperature, and the figures for 5 days are 24, 25, 25, 26, 30. That gives an average value of (24+25+25+26+30)/5 = 26. The absolute variations from the average are –2, –1, –1, 0, 4 respectively for the 5 days. A series of arithmetical manipulations are done on these variation data (squaring, adding, averaging and taking the square root of the average) to arrive at the standard deviation.

Investors need not be math wizards to understand and apply the Bollinger Bands tool - thanks to readily available charting software. But it is always good to know the concept behind the tool. So, what are Bollinger Bands?

It is a technical tool to measure the volatility in prices of a stock or commodity. It consists of a band with three lines. The one in the middle is a 20 period simple moving average (SMA) of the price. The two other lines – one 2 standard deviations above and the other 2 standard deviations below the 20 period SMA – complete the band.

Volatility is measured by standard deviation. As volatility increases, the Bollinger Bands automatically widen. When volatility decreases, the bands contract. Since standard deviation is calculated using a 20 day SMA, a 20 day SMA is also used as the middle line in the daily price charts.

The 20 day SMA with the upper and lower bands 2 standard deviations away is the most commonly used set-up in Bollinger Bands. But other combinations can also be used, depending on price volatility and investment styles. Standard deviation values are higher for stocks (or commodities) trading at higher prices than those trading at lower prices. A higher value of standard deviation doesn’t necessarily mean higher volatility.

Now let us take a look at Bollinger Bands drawn on the 1 year bar chart pattern of Tata Steel:

How do we interpret Bollinger Bands? They do not give ‘buy’ or ‘sell’ indications by themselves, but are used together with other technical indicators to confirm a ‘buy’ or ‘sell’ decision. A contraction of the bands can be used as an early indication of a price rise. Note the contractions in Jun ‘10, Aug ‘10 and Nov ‘10, which were followed by sharp up moves.

If prices keep touching the upper band on a regular basis, it is a sign of ‘overbought’ conditions, usually followed by a correction. Sep ‘10 and Dec ‘10 show such overbought conditions. If prices keep touching the lower band regularly, it is a sign of ‘oversold’ situation, usually followed by a rally. May ‘10 and Jun ‘10 are examples of oversold situation.

Note that the RSI and slow stochastic also confirmed the overbought and oversold conditions on the stock chart. Charts can remain overbought or oversold for long periods. So, selling when the price touches the upper band or buying when price touches the lower band may not be a good idea. A useful strategy when the chart is overbought is to maintain the 20 day SMA (middle line) as a trailing stop-loss. (If you have read my eBook, you will know what a trailing stop-loss is used for. If you haven’t read my eBook yet, why not? It is FREE.)

Some times the price moves above the upper band, or below the lower band. That doesn’t mean that these are sell or buy signals. It gives an indication of relatively higher or lower prices. Note that in Feb ‘11, the stock reached a lower bottom (below the lower band) while the RSI made a higher bottom. This positive divergence gave a ‘buy’ signal.

In Jun ‘10, the stock also reached a lower bottom, but failed to even touch the lower band. This was an early sign of a possible trend reversal. A ‘buy’ signal was generated because the RSI made a higher bottom.