Advance Decline Ratio is used to determine the momentum in the market by looking at the difference between advancing and declining periods.
It was originally developed for stock trading when traders wanted to look at the difference between advancing and declining stocks on the New York Stock Exchange.
ADR = No. of advancing periods / No. of declining periods
Another way to use the indicator is to see when the indicator diverges from the price. In the above example, the price has continued to fall but the ADR is rising. This can indicate a reversal in trend and following this, the price then starts to rise.
This is because fewer participants take part in driving prices down which eventually leads to a change in market direction.
ADR crossing above 1— an uptrend is established.
ADR crossing below 1 — a downtrend is established.
If the ADR is rising and the price rising you have a healthy trend. If the ADR is falling and price falling the trend is healthy. If there is a divergence between the ADR and the price the trend may change. When the indicator reads further from the 0 level the stronger and most likely mature the trend is.
This ADR is widely used as an overbought or oversold indicator where readings well above or below the 0 level could indicate reversal areas. The main issue is products can remain overbought or sold for a long period so other indicators must be used to confirm entry points. Markets can remain irrational longer than an investor can remain solvent.