Breadth of Market Theory - Explained
What is the Breadth of Market Theory?
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Table of ContentsWhat is the Breadth of Market Theory?How Does the Breadth of Market Theory Work?Types of the breadth of market indicatorsAdvance/Decline Ratio (ADR)Calculating Advance/Decline Ratio Advance/Decline Line (A/D)Calculating the advance/decline line The Formula for Calculating A/D Interpreting A/D Uses of Breadth of Market TheoryLimitations of Breadth of Market TheoryAcademic Research on Breadth of the Market Theory
What is the Breadth of Market Theory?
The breadth of the market theory refers to a technical analysis model used to forecast the future market strength and according to the number of securities that rise or fall in a market. Technical analysts use this model to predict whether there is going to be a rise or a drop in the market value. The breadth of market theory can also be referred to as the breadth of the market indicator.
How Does the Breadth of Market Theory Work?
The breadth of market theory is used to measure the securities rising or dropping in a market. In the breadth indicator is steady, it is an indication that there will be a rise in the market. On the other hand, if the breadth indicator is weak, it is an indication that the market will drop. For instance, if a market consists of 120 stocks and 90 stocks gains in terms of price, while 50 stocks either experience no change or drops in price, then, as per the breadth of market theory, this is an indication that the market is strong. As a prediction tool, the breadth of market theory does give a hint of market momentum. There are usually market trend patterns ranging from the strong economic climate, basics, or a promising market cycle. Potential investors can make use of this trend to their advantage if they are able to recognize inflection points soon.
Types of the breadth of market indicators
There are several numbers of the breath of market indicators, and each one of them has its own calculation method. Others are cumulative while others are non-cumulative.
- Cumulative- This is where each day value is either added or subtracted from the earlier value.
- Non-cumulative-It means that each day or time provides its own data.
The following are different methods of breadth market indicators:
- Advance/Decline Ratio (ADR)
- Advance/Decline Line (A/D)
- One balance Volume
- Chaikin Oscillator
- McClellan Summation Index
- Arms Index (TRIN)
Note that all of the above are methods of calculating the breadth of market theory. However, Advance/Decline Ratio (ADR) and Advance/Decline Line (A/D) are the most popular methods that dealers of market breadth theory work with.
Advance/Decline Ratio (ADR)
Advance Decline Ratio is used to compare the previous and current ratio of stocks. It looks at the number of stocks that closed higher versus those that closed lower than their previous closing price. In other words, we can say that ADR is a measure of stocks that are rising against those that are dropping. The ADR, therefore, is a technical pointer of the breadth of market decline or advance.
Calculating Advance/Decline Ratio
To calculate ADR, you are required to divide the number of advancing shares by the number of declining shares. (Advance Decline Ratio = Stocks Advancing/Stocks Declining). Note that, advance/decline ratio can be calculated on various time periods usually in one day, a week or even one month.
Advance/Decline Line (A/D)
Advance/decline line also commonly known as A/D, measures the breadth of the markets trend. It monitors changes in the value of the A/D index over a particular period of time. It enables analysts to gauge if a rise or a fall in a market index, is determined by either a few or a larger number of stocks.
Calculating the advance/decline line
To calculate A/D, you need to find the difference between the number of advancing/declining issues, and then add the outcome to the previous periods value.
The Formula for Calculating A/D
A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Previous Periods A/D Line Value.
Users of A/D ratio do interpret it in a number of ways as explained below:
- A ratio that is rising over time is a sign that the market trend is strong while a ratio that is dropping is an indication of a weak market trend.
- A relatively high ratio may be a pointer of an overbought market (that which is nearly declining and investors sell shares to get their profits).
- A relatively low ratio is a sign of an oversold market (that which is about to increase its price and investors buy shares at a negotiable price.
It is important to note that, business people use market breadth indicators together with other forms of metrics such as chart patterns and technical indicators, to capitalize on their success.
Uses of Breadth of Market Theory
You can use the breadth of the market to achieve the following:
- The breadth of the market theory is able to show investor whether or not stocks in the market are performing well. Traders can, therefore, be able to take caution so that they don't channel their money in an already declining market.
- It can also be used by investors to assess the strengths and weaknesses in various stock indexes. This way, they can be able to get ideas on what the index is likely to do in the future. It provides information on whether the market uptrend or downtrend is expected to go on.
Limitations of Breadth of Market Theory
- Breath of market theory is unreliable. This is because it sometimes predicts index hitches too early, and sometimes too late or not at all. This can be a setback to investors who want reliable information to help them make an informed decision regarding their investment.
- Some breath indicators are likely to give odd results because of their working formula methods. Inaccurate results may be catastrophic to an investor who is relying on breadth indicators to make an investment decision.
- Also, some breath indicators may encounter situational variances which may result in anomalies in the results being generated.
Academic Research on Breadth of the Market Theory
- A simple model of capital market equilibrium with incomplete information, Merton, R. C. (1987). The journal of finance, 42(3), 483-510.
- Advertising, breadth of ownership, and liquidity, Grullon, G., Kanatas, G., & Weston, J. P. (2004). The Review of Financial Studies, 17(2), 439-461.
- Does market orientation matter?: A test of the relationship between positional advantage and performance, Hult, G. T. M., & Ketchen Jr, D. J. (2001). Strategic management journal, 22(9), 899-906.
- Market breadth and the Monday seasonal in stock returns, Sullivan, J. H., & Liano, K. (2003). Quarterly Journal of Business and Economics, 65-72.
- Breadth of ownership and stock returns, Chen, J., Hong, H., & Stein, J. C. (2002). Journal of financial Economics, 66(2-3), 171-205.
- Investor sentiment in the stock market, Baker, M., & Wurgler, J. (2007). Journal of economic perspectives, 21(2), 129-152.
- The effects of industry growth and strategic breadth on new venture performance and strategy content, McDougall, P. P., Covin, J. G., Robinson Jr, R. B., & Herron, L. (1994). Strategic Management Journal, 15(7), 537-554.
- Trading volume, time-varying conditional volatility, and asymmetric volatility spillover in the Saudi stock market, Alsubaie, A., & Najand, M. (2009). Journal of Multinational Financial Management, 19(2), 139-159.
- International expansion by new venture firms: International diversity, mode of market entry, technological learning, and performance, Zahra, S. A., Ireland, R. D., & Hitt, M. A. (2000). Academy of Management journal, 43(5), 925-950. Market liquidity and its incorporation into risk management, Bervas, A. (2006). Financial Stability Review, 8(May), 63-79.
- Creditor rights and the credit market: where do we stand?, Galindo, A. J. (2001).