Trend Trading Using Advance Decline Index

By Dan Pipitone

Trading the trends is one of the most followed stock trading strategies. Long traders buy stocks at the start of an uptrend and sell them when the trend diminishes. Similarly short traders take short positions at the start of a downtrend and close there positions when the trend ends. Sounds like a very good strategy! But the problem is "how can we know a trend is starting or ending" and "is the trend has enough strength to bring prices to new highs or lows". A simple but effective tool to solve this problem is the "Advance - Decline Index or A-D Index"

Advance - Decline index measures the strength of a market movement. It is one of the most widely used trend analyzing tools by short-term and long-term traders trading all types of financial instruments - stocks, bonds, currencies, futures, etc. AD index is defined as the 'difference between total number of bullish or advancing stocks and total number of bearish or declining stocks'. The value can be a positive or negative integer. But with this single value analyzing trend strengths is difficult. So traders plot this value on a chart as an 'Advanced-Decline line', connecting points of each time periods. One point of the line can be derived from a simple formula.

A-D point = A-D value of the period + A-D value of previous period.

The period can be of any time frame; day traders can use short time periods like 15 or 30 minutes or 1 hour, other traders can use daily, weekly or monthly periods. Most trading systems today have AD index as a standard indicator.

Interpreting advance-decline indicator is easy.

1. Market up and AD down - Strong uptrend.

2. Market up and AD up - Weak uptrend.

3. Market down and AD down - Strong downtrend.

4. Market down and AD up - Weak downtrend.

The major advantages of AD indicator are its simplicity and scalability. It can indicate trend weakening and possible trend changes. But AD index cannot be used as a main tool to predict trend reversals. Traders should use other indicators like volume indicators, Fibonacci tools together with AD index to predict trend changes.

NobleTrading is an Online Stock Trading Broker offering flexible commission plans and direct access trading systems. NobleTrading also offers online OTCBB stock trading service which allows over-the-counter traders to place their orders online.

Article Source: http://EzineArticles.com/?expert=Dan_Pipitone

http://EzineArticles.com/?Trend-Trading-Using-Advance-Decline-Index&id=2128477

For more information on technical analysis topics such as Advance Decline Index and Advance Decline Line please visit StockMarketStudent.com

Stock Trading System Development

Most people invest in the stock market but only a very few go to the effort of designing their own stock trading system. By "system", I mean a piece of software that automatically tells the trader when to buy and sell stocks. There are several advantages to mechanical stock trading systems. One of the big advantages is that it removes the emotion from the trading activities. Or should I say, a mechanical stock trading system should remove the emotion from trading.

In fact, most system traders tend to seek the highest possible return on capital without accounting for the emotions experienced when real money is on the line. As a result, many traders make fundamental mistakes including underdiversification, undercapitalization and overtrading.

One significant issue that novice system developers face is the assumption that live performance of a trading system will mimic system backtest performance. It is very unusual to achieve similar performance live as was achieved in simulation. A good rule of thumb is to expect 50% of the profit and 50% higher drawdown in live trading as opposed to backtest simulation.

Inevitably, a mechanically traded stock system will produce a fairly significant drawdown. This is where emotion comes into play. It is very easy to study a backtest simulation and come to the conclusion that you can tolerate a 25% drawdown. It is a completely different situation when you are down 25% with real money invested. In this situation traders typically begin to question whether their system still works. With enough stress the trader will liquidate his (or her) holdings. This is how traders end up buying high and selling low. It complete cycle is greed and fear. Greed comes into play because too much capital is put into the stock positions initially. Fear comes into play when the positions move against the stock holder. The root cause is typically deployment of too high a percentage of one's trading capital on non-diversified positions. This is often compounded by use of capital that one cannot afford to lose.

Before embarking on the design of your own personal trading system you should first assess your personality, lifestyle and financial means. There is no point in putting a great deal of effort into a trading system that is ultimately unsuitable for your life's situation.

Steve Auger is the author of the blog Stock Market Student. Always strive for the highest Alpha when developing a stock trading system.

Stock Liquidity

When buying or selling shares in a company, most traders want to ensure they are doing so at a fair price. In many cases novice traders fail to get a fair price because they don't understand stock liquidity and a factor called slippage.

What is slippage?

Slippage is the difference between the last trade price and the price realized by the next order. Typically, slippage occurs when there is a significant imbalance between demand and supply. For example, if a stock trader wants to buy 10000 shares of a stock but the average daily volume shares traded for that stock is 5000 shares, then there will likely be a great deal of slippage in acquiring the stock. The act of buying the stock will drive up the share price because there are not enough willing sellers.

One method of preventing slippage is to use limit orders instead of market orders. But there is a downside to this. Quite often the stock trader does not acquire the best stocks with limit orders because the price moves up too fast. Or the trader will get filled on a miniscule number of shares and has to chase the stock by moving up the limit price to acquire more. Neither of these situations are desirable.

Stock Liquidity

When developing a stock trading system, it is good practice to determine the minimum stock liquidity for your needs. For example, if a stock trader starts with $100K trading capital and plans on holding 20 different stocks then he will typically be buying $5K worth of stock at a time. To avoid major slippage problems the stock trader will likely set certain minimum stock liquidity requirements to filter out low liquidity stocks.

Average Trading Volume

Many novice traders will filter out low liquidity stocks by examining the stock average trading volume over the previous 20 days. 20 days is generally not sufficient as a large volume spike on one or two days can skew the average trading volume. You can end up holding a stock with volume dying off rather quickly. So it is better to a longer averaging period such as 60 days.

Average Dollar-Volume

An issue with examining the average daily trading volume is that it is not necessarily the right factor to monitor. For example, For example, some stocks on publicly traded exchanges have extremely high valuation, $1000 or more. The stocks can be quite liquid and one share can easily be bought. So you can see that trading volume is actually irrelevant. What is important is average dollar-volume. In other words, concentrate on the $$$ turned on an average trading day, not the volume of stocks traded.

The minimum stock liquidity for stocks the trader is interested in buying should be based on trading capital and number of stocks held. For the case mentioned above the trader has $100K trading capital and wants to hold at least twenty stocks. On average each position will be $100,000 / 20 = $5,000. When you buy a stock, a good rule of thumb is to buy no more than 1% of the 60 day average daily dollar-volume. For this trading example, the minimum stock liquidity level should be a minimum $500,000 daily average traded for a particular stock.

Market Capitalization

Now the average dollar-volume is fine for acquiring a stock position but what about exiting? When a sell signal comes up the trader will have to sell regardless of the average dollar-volume. In preparation for selling a stock, consider using market capitalization as a filter before buying the stock. The idea is that if the market capitalization is too low then stock liquidity is likely a problem, even if the dollar-volume is high. This provides some buy side filtering for consideration of ultimately selling the stock.

Stock Price

The final parameter to consider is the current stock price. It is a good idea to avoid stocks trading under $3. There is too much speculation/manipulation for these stocks and they tend to be less liquid.

Conclusion

To avoid having excess slippage when entering trades, make sure you consider the stock liquidity (average dollar-volume), market capitalization and stock price. If you want to trade more than 1% of the stocks average dollar volume then consider breaking the trades into several different orders to manage slippage.

Steve O. Auger is the author of the blog Stock Market Student and Stock Market Encyclopedia.