Summary - Experienced investors understand the important relationship between price movement and volume. When a price moves in an upward or downward trend and is supported by strong volume, it not only confirms but can validate that trend. The accumulation/distribution (A/D) line gives traders a visual representation of this fundamental relationship between supply and demand. When the ADL for an asset rises as the price of an asset rises, it means traders are still in the accumulation stage. Conversely, when the ADL for an asset decline as the price declines, it means traders are still distributing (or selling).
The formula for accumulation/distribution is:
Accumulation/Distribution = Money Flow Multiplier * Period Volume
The Money Flow Multiplier shows the relationship between a period’s closing price and the high/low price range for that same period. The A/D line is considered a cumulative indicator because it uses the multiplier from previous periods to string together the A/D line. With that in mind, the key to understanding the A/D line is the Money Flow Multiplier, which is what will make the ADL rise or fall.
Investors use the ADL to check for both trend confirmation and divergence. When the ADL is rising or falling in the same direction as the price, it is a strong signal that the price will continue to move in that direction. Conversely, when the ADL and price movement are moving in opposite directions, it can be a bearish signal that a stock is overbought or a bullish signal that the stock is oversold. Either way, it is suggesting that the price of an asset is about to move in the opposite direction.
Two of the limitations of the ADL occur when there is a gap in price between trading periods as the ADL does not account for these occurrences. Also, although one of the benefits of the A/D line is how it confirms an existing trend, it is less accurate when it comes to divergence which can take a long time to manifest itself if it does at all.
One of the simplest concepts in economics throughout history is that of supply and demand. Simply put, when demand exceeds supply, the price of those goods or services is going to go up. Conversely, when supply exceeds demand, the price goes down. The same concept of supply and demand takes place in the buying and selling of financial instruments. When there are more investors looking to buy a stock than those that are selling, it will cause prices to rise. Likewise, when there are more investors looking to sell a stock than there are buyers, the prices will decline to signal a bearish reversal. However, when it comes to investing, the price movement is also closely related to volume. Professional traders profit by capitalizing on the relationship between stock prices and volume. One way to do this is by using technical analysis to detect chart patterns, and one of the best tools to help traders understand the relationship between supply and demand is the accumulation/distribution indicator. This article will break down what the accumulation/distribution indicator is, how it is calculated, and how investors can use what they see to inform their investing decisions.
What is the accumulation/distribution indicator?
Accumulation/distribution looks at the proximity of a closing price to its high and low price to determine if more traders are buying (accumulating) or selling a particular security. The accumulation/distribution (A/D) indicator (also called the Accumulation Distribution Line or ADL) is a technical indicator that uses volume to measure the underlying supply and demand for an asset. By watching the A/D indicator investors can see the buying (accumulation) or selling (distribution) activity of an asset. This is significant because the ADL can reveal a cumulative total of a period’s Money Flow Volume, which essentially allows investors to follow the money to see how divergences between volume and price can either confirm a current trend or be an early predictor of a change in direction.
The A/D indicator is similar to the On-Balance Volume (OBV) which is also a cumulative indicator. In the case of the OBV indicator, all the volume on up days is added and all the volume on down days is subtracted. If security closes higher than the previous day's close, all the volume is considered up-volume. Likewise, when a security closes lower than the previous day's close all the volume is considered down volume. This represents both the simplicity and the limitation of this indicator.
What is meant by buying and selling pressure?
Buying and selling pressure is determined by what side of a trade the majority of traders take regarding a specific asset. Buying pressure occurs when the majority of traders are attempting to buy a specific asset, buying pressure increases. A good example of when buying pressure may increase is when a company issues an earnings report that exceeds expectations for either revenue, earnings per share (EPS) or both. Buying pressure can also occur when a stock is perceived to benefit from the release of a leading indicator. For example, the price of oil usually gets buying pressure when the unemployment rate declines because there will be a perceived need (real or imagined) for more gasoline.
Selling pressure occurs when the majority of traders are attempting to sell a particular asset. This can occur when a company does not meet expectations in an earnings report. Selling pressure also occurs when a company faces a product recall or when analysts perceive the company and its stock to be affected by economic news. A good example of this has been the United States trade dispute with China that began in 2018 and continues to affect some industries as of this writing.
What is the formula for the accumulation/distribution indicator?
The formula for accumulation/distribution is as follows:
Accumulation/Distribution = Money Flow Multiplier * Period Volume
The A/D line is considered a cumulative indicator because it builds upon the data from previous periods to string together the A/D line. With that in mind, the key to understanding the A/D line is the Money Flow Multiplier, which is what will make the ADL rise or fall. The Money Flow Multiplier shows the relationship between a period’s closing price and the high/low price range for that same period. The formula for the Money Flow Multiplier is:
((Close – Low) – (High-Close)) / (High – Low)
Close = closing price for the period being measured
Low = the lowest price for the period being measured
High = the highest price for the period being measured
A stock has a closing price of 25.25 with a high of 28.12 and a low of 24.78
The Money Flow Multiplier will be:
((25.25-24.78) – (28.12-25.25)/ (28.12-24.78) =
((0.47) – (2.87) / 3.34
-2.4/3.34 = -0.71
Interpreting the Money Flow Multiplier
The Money Flow Multiplier will always fall within a range of -1 to 1. When the closing price of a period is within the upper half of the high/low range, the Money Flow Multiplier will rise closer to 1. A positive number signifies buying pressure. The closer the number is to 1, the stronger the buying pressure. Conversely, a negative number signifies selling pressure. The closer the multiplier is to -1, the stronger the selling pressure.
How does period volume relate to the accumulation/distribution line?
Period volume can be thought of as the accelerant for the ADL. The multiplier indicates buying and selling pressure and the period volume indicates how far the ADL will rise or fall. In our example above, a multiplier of -0.71 combined with high trading volume would cause the ADL to fall sharply. If the trading volume was low, the ADL would still fall, but the movement would not be as sharp, which may indicate that there is not strong selling pressure.
Using the accumulation/distribution line for trend confirmation
Now that you can see how the ADL is calculated, let’s take a look at how traders can use it to inform their trading decisions. When an asset is in a strong upward or downward trend, the ADL will move in the same direction as the asset price, thus confirming the existing trend.
Using the accumulation/distribution line to interpret divergence
Of course, there will be times when the ADL will diverge from the trend line. Many traders look at volume as a signal that will always precede price movement. So when trading volume begins to move in the opposite direction of price (i.e. volume slows while prices are rising; volume increases while prices are falling), the ADL will show divergence from the observed price trend and can be a signal that a correction is likely.
In a bullish divergence, the ADL trends upward while the asset price is in a downtrend. In this case, ADL is a signal of buying pressure (i.e. accumulation). This means traders are starting to accumulate shares. When this ADL is combined with high trading volume, it is a signal that a price correction to the upside is likely.
In a bearish divergence, traders will notice an ADL that is trending downward even as the asset price is in an uptrend. Knowing that this pattern is signifying selling pressure, if traders observe this pattern that is combined with high trading volume, it is a signal that a price correction to the downside is likely.
Is the accumulation/distribution line a reliable indicator?
Like any indicator, the ADL is not a perfect indicator. The reason for this is that the Money Flow Multiplier, which is the key factor in determining the direction of the ADL line, does not factor in the change in price range between two periods. It is common for assets to register a significant change in price that occurs without any trading taking place. This is what’s known as a price gap. Price gaps occur when buying or selling pressure becomes extreme or upon the release of some news or analyst report. Let's look at a stock that moves down 18% in pre-trading on news that it failed to meet analysts' expectations. When the stock opens, the price oscillates throughout the day and ends up down 15%. In this case, the stock price ends up in the upper part of its trading range, but will still be down significantly from its previous close. In this case, the formula for the ADL is not designed to register a gap in price. This means, in this instance, the ADL can be out of sync with the price chart.
Another potential limitation of the ADL occurs in a divergence pattern. Although a stock may be showing the proper set up for a price correction, the actual correction may not occur right away, and ultimately may not reverse.
This is why the ADL, like all indicators, should only be one form of technical analysis used by traders. By testing a security, such as a stock, with momentum indicators such as its moving average or with the relative strength index (RSI), investors may get a clearer confirmation of an overbought or oversold security. In some cases, it may be necessary to perform some fundamental analysis, to determine what is really causing price movement.
The final word on the accumulation/distribution indicator
The accumulation/distribution indicator gives investors a visual representation of the relationship between volume and price movement. The indicator shows times of increasing buying pressure (accumulation) and selling pressure (distribution) and uses a multiplier to show the intensity of that pressure. The accumulation/distribution indicator uses the data over different periods to plot an accumulation/distribution line (A/D line). This line will either confirm a trend or show divergence. The A/D line is less reliable when showing divergence because an asset may diverge for quite sometime before the price correction occurs.