The first step in creating the accumulation/distribution (A/D) line is finding the close location value (CLV), which looks at the location of the close and compares it to the range for a given period (one day, week or month). The CLV will have a value from +1 to -1:
- A value of zero would mean that the price closed halfway between the high and low of the range.
- A value of +1 means the close is equal to the high of the range.
- A value of -1 means the close is equal to the low of the range.
CLV = ([(C-L) - (H - C)] / (H - L))
Where:
C = the closing price
H = the high of the price range
L = the low of the price range
The CLV is then multiplied by the corresponding period's volume, and the total will form the A/D line. (For a look at the CLV's precursor, the on-balance volume, read Introduction To On-Balance Volume.)
Benefits and Drawbacks of Using the A/D Line
In some instances, using the A/D line can give traders a clear advantage:
- Monitor General Money Flow - The A/D line can be used as a gauge for the general flow of money. If the A/D line is moving higher, this signals that there is buying pressure that is starting to prevail. On the flip side, if the A/D line is moving downward, this signals that increased selling pressure is beginning to gain a foothold.
- Confirmation - You can also use the A/D line to confirm the strength, and possibly the longevity, of a current move.
- Trading Gaps - The A/D line does not take trading gaps into consideration, so these gaps, when they occur, may not be factored into the A/D line at all. Therefore, if a stock's price has gapped upward but closes around the midpoint, that gap will be ignored because the A/D line is formulated using closing prices. (To learn about profiting from trading gaps, read Playing The Gap.)
- Minor Changes - Sometimes it can be difficult to detect minor changes in volume flows. The rate of change in a downtrend could be slowing, but this would be difficult (if not impossible) to detect until the A/D line turned upward. (To learn how to monitor trends in volume, read Volume Rate Of Change.)
The A/D line creates both bullish and bearish signals. These signals rely on divergence and confirmation.
Bullish Signals
Bullish signals occur when the price of a security is moving down or is in a downtrend, but A/D line is trending upward (see Figure 1). This divergence signals increased buying pressure, which can indicate weakening seller strength. It is usually followed by a change in the trend of the security from downward to upward.
Spotting a Divergence
In order to spot bearish and bullish signals, you need to have a trend in the underlying security. Once this has been established, you can begin to look for a divergence from that trend. When spotting these divergences, either bullish or bearish, it is best to allow a week or two for the signals to develop. When it comes to bearish patterns, you want to keep an eye out for signals that are flat or do not have a sharp divergence – these can also signal that no future change is probable. (For more information, see Divergence: The Trade Most Profitable.)
Other Indicators
There are other indicators that can be used along with the A/D line.
Money Flow Index
The money flow index (MFI) is a volume-weighted momentum indicator. This indicator compares positive money flow to negative money flow and creates an indicator that can then be compared to the price of the security to identify the current strength or weakness of a trend. It is calculated using a 14-day period.
The MFI has a scale from 0-100. This scale is a range:
- A security that is close to 100 usually signals an overbought position. In reality, an overbought position can be signaled by an MFI value around 80.
- A security that is near zero will signal an oversold position. A value of around 20 usually qualifies a position as oversold. (For further reading, see The Basics Of Money Flow.)
Another indicator that can be used with the A/D line is the relative strength index (RSI), a momentum oscillator. The RSI is calculated by taking the magnitude of a stock's recent gains and comparing it to the magnitude of a stock's recent losses. The RSI has a number range from 0-100. Like the MFI, it is used primarily to highlight overbought and oversold conditions. The RSI is best used as a complement to another technical tool to analyze a security. (To learn more, read Ride The RSI Roller coaster.)
Combining Indicators and Oscillators
While using the A/D line by itself is indeed feasible, it is even more advantageous to add either the MFI, the RSI, or both. Since the MFI and RSI both give a range, they can be used to spotlight extreme conditions that the A/D line was not designed to spotlight.
While the RSI and MFI both attempt to highlight overbought or oversold positions, they go about it in different ways:
- The MFI measures the flow of money into a security, whether that money is positive or negative.
- The RSI compares the magnitude of a stock's recent gains to its recent losses.
Neither of these technical tools overlaps, so they can indeed be used in conjunction with the A/D line. (For more information, see our Exploring Oscillators And Indicators tutorial.)
Conclusion
The accumulation/distribution line is an effective tool for spotlighting buying and selling pressure on a security. It is also a fantastic way to confirm an existing trend. Using the A/D line alone is one way to analyze a security, but it can also be used with either the MFI or the RSI to refine the analysis. Since both the RSI and MFI work well with the A/D line, using them together can help you get a better sense of overbought or oversold situations. In the end, the A/D line is an effective tool in any trader's arsenal
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