Breadth information is available for the different exchanges, including Advancing Issues and Declining Issues for the NASDAQ used in this article. These values are based on the NASDAQ Composite Index (COMPQ). Since index construction can change over the years, normalizing the data may help indicator readings remain more consistent over time.

Last week, rather than using the straight Advancing Issues minus Declining Issues data for the NYSE Composite A-D Line, the data was viewed as a ratio with the Advancing Issues minus Declining Issues value in the numerator and the total issues traded (Advancing Issues + Declining Issues + Unchanged Issues) in the denominator. This week a different approach will be used to address changing characteristics over time, along with a first look at a potential system for the indicator.

Proxy Security

QQQQ is the exchange traded fund [ETF] based on the Nasdaq-100® Index and one of the most actively traded securities on major exchanges. The index includes the top 100 stocks traded on the NASDAQ exchange, excluding the financials. As a result, this index proxy has fared a bit better than the broad-based S&P 500® Index which was heavily weighted with financial stocks at the beginning of the recent bear market.

Although the COMPQ is comprised of 2,842 securities including financial stocks, the correlation [r] of returns for this index versus QQQQ using almost 4-1/2 years of data is 0.975 on a daily basis. This translates to an r2 value of 0.95, which is very strong. Given this strong relationship, QQQQ is considered an acceptable proxy security for COMPQ and will be used in the charts provided since the ETF can be traded.

Different Time Span Views

Figure 1 provides QQQQ closing data (blue line) and the NASDAQ Composite Adv/Dec Ratio data (red line) from 1/2005 through 6/2009. QQQQ closing values, Advancing Issues and Declining Issues where all downloaded from Worden Brothers TeleChart® 2007. Since there is a good deal of time covered in the graph, focus on the two horizontal lines at the top edge of the A/D Ratio line.

Figure 1: QQQQ Daily Chart with COMPQ Adv/Dec Ratio (1/2005 - 6/2009)
click here for larger view

The lower grey line displayed with the A/D Ratio is the average A/D Ratio reading + 1 standard deviation [SD] using ratio values from early 2005 to this past week. The darker, higher line is the + 2 SD level. The four year cycle low in the spring of 2006 produced some unusually high ratio readings relatively to previous data.

The ratio readings calmed down from the cycle low until late summer 2007. As expected, the values became more extreme in late 2008 early 2009. To provide slightly more detail, Figure 2 provides the QQQQ and A/D Ratio data from Jan 2007 through this past week.

Figure 2: QQQQ Daily Chart with COMPQ Adv/Dec Ratio (1/2007 - 6/2009)

In addition to the grey +1 SD line that incorporates all data from Figure 1, an average -1 SD line was added (also grey), as well as +1 and -1 SD lines (green) using values from 1/2007 to present. The average value of the A/D Ratio was higher in the second, shorter period (1.147 versus 1.115) as was the extent to which the data was dispersed (SD value of 0.897 versus 0.784).

Two blue horizontal lines were also added to highlight extreme lows in the ratio - those beyond the green average - 1 SD level. It appears these ratio lows correspond with an ETF low that sees a short-term advance. This assessment is better viewed in Figure 3, which provides the same data from Aug 2008 through this past week.

Figure 3: QQQQ Daily Chart with COMPQ Adv/Dec Ratio (8/2008 - 6/2009)

Not every extreme low in the ratio corresponds with an ETF low and not every extreme high in the ratio corresponds with a temporary peak in the ETF, but it does appear there is something worth testing.

A Contrarian Edge from the A/D Ratio

Extreme values for different breadth measures may be used as a contrarian tool. Given the changing nature of exchanges and markets in general, breadth readings can also change. Rather than using a specific value to denote market extremes, traders may want to consider using a representative average +/- some number of SDs to identify extremes. The question is: how do you decide when to update your readings?

Traders can use a few different approaches to update extreme readings for indicators. Ideally the approach will be objective while still remaining in tune with current market characteristics. A first test looked at creating a long position in QQQQ at the open the day after an extreme low was reached. The test data used NASDAQ A/D Ratio values below 0.308 as a trade signal, which is close to the average minus 1SD value using all data (0.332). Returns for trade exit at the close one day later, two days later ad three days later were assessed.

The average return was modest, but with a short-term holding period (lower risk), multiple signals throughout the year and compounding of returns, seemed worth exploring further. However, to maintain the appropriate number of signals, an adaptive technique for setting the A/D Ratio trigger level is necessary. Next week a closer look at the original test data and methods for revising the trigger will be explored.


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Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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