Market Breadth Indicators: An Important Measure of Sentiment

04/23/2015 6:00 am EST

Focus: STRATEGIES

Bob Lang

Founder and Chief Analyst, Explosive Options

For the benefit of newbie traders or for anyone in need of a refresher, Bob Lang, of ExplosiveOptions.net, discusses market breadth and outlines the benefits of three crucial indicators; the McClellan oscillator, the ARMS Index (TRIN), and the Chaikin oscillator.

Market breadth is an ideal way to gauge the temperature of the market’s health at any point and at any time. Like most indicators, it provides an idea of where price action is likely headed.

Market breadth is simply how many stocks are being bought vs. being sold and how much volume is behind it. It does not tell us what sector, stock, or index people are buying into; rather, it tells us whether money is flowing in or out of the market as a whole. Coupled with other sentiment tools, such as the put/call ratio, volatility index, rydex ratio, and polls, we can get a very accurate idea of what investors and traders are thinking and doing, thus giving us some powerful predictive reads. Of course, our analysis of these indicators is not always perfect, and usually, our timing will be off, but sentiment is a valuable tool in our toolbox. Properly reading current market breadth indicators give us a leg up.

Naturally, there are several different market breadth indicators out there. In general, they provide us the same information but present that information slightly differently. Let’s take a look at three of them.

McClellan Oscillator

The one I use the most is called the McClellan Oscillator, which was developed by Sherman and Marian McClellan in 1969 as a “tool for measuring acceleration in the stock market.” At the time, the industry had very few prominent technicians, so the Oscillator was widely adopted.

At its most basic, the tool takes end-of-day data and presents it in cumulative chart form. The data includes an advance/decline line and daily breadth. Taken together and then smoothed using mathematics, (10% and 5% EMAs for trend analysis), an oscillator is created. The key, of course, is interpreting the reading to understand where the market may be trending or if it’s reaching the end of a trend (overbought or oversold).

By itself, the McClellan Oscillator is a great tool, but its summation index, which accumulates all the values, provides an even better reading, as we can see a trend’s power, strength, and potential for continuation.

Arms Index (TRIN)

Dick Arms was the first trader to recognize a strong relationship between depth and breadth, so he corralled them into a very simple reading called the Arms Index, or TRIN (Traders Index) that uses a ratio of advancers/decliners divided by up/down volume. In general, a reading over 1 is considered bearish; under 1 is bullish.

I have found this to be a great contrarian tool at the extremes. Very high readings of around 1.5 indicate the bears are routing the bulls. If the reading lasts 14 days, a powerful rally should ensue soon. A very low reading of .4 means too many bulls are on the bus and a reversal downward in the markets will soon happen.

Chaikin Oscillator

The Chaikin Oscillator interprets the accumulation/distribution of the MACD (moving average convergence/divergence). The oscillator is intense and noisy; it subtracts a 10-day EMA from a 3-day EMA of the accumulation distribution line and it outlines the momentum implied by the accumulation distribution line. The stronger the reading, the more momentum in price action.

These valuable market indicators should definitely be added to your trader’s toolbox, as they can help you determine momentum, trend, and strength. These are very reliable tools, but you’ll reap the greatest rewards when you use them in conjunction with others to confirm your analysis.

By Bob Lang of ExplosiveOptions.net

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