Understanding the Advance-Decline Ratio for Analyzing Supply and Demand Trends in Stock Markets

The "Advance-Decline Ratio" is one of the important indicators for grasping supply and demand trends in financial markets. In the stock market, the Advance-Decline Ratio indicates the ratio of advancing stocks to declining stocks over a certain period and is used to measure market overheating or undervaluation. This article explains the overview, features, limitations, and investment strategies utilizing the Advance-Decline Ratio.

1. Overview

The Advance-Decline Ratio is an indicator calculated by taking the ratio of the number of advancing stocks to the number of declining stocks in the stock market over a certain period (generally (in many cases) a short term of 6 days (or 10 days), a medium term of 15 days, or a long term of 25 days). It is used to measure the overall strength or weakness of the market and serves as an important clue for determining whether the market is overheating or in a correction phase.

The Advance-Decline Ratio is calculated using the following formula:

Advance-Decline Ratio = (Total number of advancing stocks over a certain period ÷ Total number of declining stocks over a certain period) × 100

• 100% is the baseline; a value above 100% indicates that there are more advancing stocks than declining stocks.

• Generally, a value of 120% or higher is considered to indicate market overheating, while 70% or lower is often considered to indicate that the market is oversold.

2. Features

The Advance-Decline Ratio has the following features:

• Ability to grasp the overall health of the market
  The Advance-Decline Ratio is used to grasp the supply and demand balance of the entire market rather than individual stocks. Because it is based on the number of advancing and declining stocks, it is possible to quantitatively measure the overall strength and momentum of the market.

• Indicator showing short-term overheating or overselling
  The Advance-Decline Ratio is suitable for capturing short-term market overheating or correction phases, which are difficult to grasp with stock price indices alone. For example, if the Advance-Decline Ratio exceeds 120%, there may be short-term overheating because there are too many advancing stocks. Conversely, if it falls below 70%, it is considered an oversold state, and it is used as a signal that the possibility of correcting an excessive supply-demand imbalance ( is expected to be perceived as a timing for buying and selling. ) increases.

• Reflects investor sentiment
  The Advance-Decline Ratio is an indicator that focuses solely on supply and demand, and it is characterized by the fact that investor optimism and pessimism toward the market are easily reflected. When the market is moving too much in one direction, there is often a bias in investor sentiment in the background, and this can be used as an indicator to capture this.

3. Limitations

While the Advance-Decline Ratio is a useful indicator, there are also some limitations.

• Extreme values can easily persist
  Although the Advance-Decline Ratio indicates market overheating or correction phases in the short term, it does not necessarily mean that it will reverse immediately. For example, even if the Advance-Decline Ratio shows a high value, the market may continue its upward trend, or conversely, it may continue to adjust for a long period while remaining at a low value. Therefore, relying solely on the Advance-Decline Ratio carries risks.

• Not suitable for analyzing individual stocks
  The Advance-Decline Ratio is an indicator for measuring the supply and demand balance of the entire market and is not suitable for analyzing the performance of individual stocks. Therefore, it is necessary to use technical analysis or fundamental analysis in combination for selecting individual stocks and formulating strategies.

• Dependent on market characteristics
  The Advance-Decline Ratio can be influenced by trends specific to a particular market or period. For example, if there is strong interest in specific theme stocks or industries, those stocks may have an abnormal impact on the market as a whole, in which case the Advance-Decline Ratio may not accurately reflect the essential supply and demand of the market.

4. Investment Strategy

Investment strategies utilizing the Advance-Decline Ratio are mainly methods for determining timing by judging market overheating or correction phases.

• Selling strategy during overheating
  When the Advance-Decline Ratio reaches 120% or higher, this suggests that the market may be overheating. In such a phase, a strategy of refraining from new purchases and taking profits on a portion of existing positions to reduce risk is effective. Also, considering a contrarian short position in anticipation of a short-term correction phase is a possibility, but in this article, we will stop at introducing it as a methodology and do not recommend it. This is because short positions carry significant risks and costs compared to holding long positions. In such a phase, it is necessary to judge the market situation while incorporating fundamentals and technical analysis indicators, and there are many cases where one cannot respond to sudden market fluctuations.

• Buying strategy for oversold conditions
  On the other hand, when the Advance-Decline Ratio falls below 70%, it increases the likelihood that the market is oversold. In this case, it is effective to view this as an opportunity to pick up undervalued stocks and consider opening new long positions. In particular, one might consider focusing on stocks with long-term growth potential and aiming for entry at low prices.

• Strategy combined with trend following
  While the Advance-Decline Ratio is used as a technical indicator on its own, it is more effective when used in combination with other technical indicators rather than in isolation. For example, by using it alongside trend-based indicators such as moving averages or the RSI (Relative Strength Index) to confirm the signals indicated by the Advance-Decline Ratio, you can make more reliable trading decisions.

5. Summary

The Advance-Decline Ratio is a very useful indicator for analyzing supply and demand trends in financial markets. It is well-suited for capturing the overall strength or overheating of the market and provides signals that reflect investor sentiment. However, because it is not suitable for situations where extreme values persist or for judging individual stocks, it is recommended to use it in combination with other analytical methods. By using appropriate investment strategies alongside the Advance-Decline Ratio, it is possible to gauge market timing and generate profits while managing risk.