Alison BloomerThe accumulation distribution indicator is an important stock selection and timing tool that helps investors with their buy or sell decisions by providing advance warning of future price movements.
It was devised by analyst Marc Chaikin in the early 1980s as a way to measure the accumulation (buying pressure) versus distribution (selling pressure) of a stock over time. As a volume-based indicator, it is designed to calculate the cumulative flow of money into and out of a security.
It is used in technical analysis to identify strengths and weaknesses in a market. In simple terms, it looks at supply and demand and how this is driving price.
Accumulation refers to how much equity of the stock is bought; distribution is how much equity of the same stock is sold. Buying pressure is represented by stocks that close high in a range, on high volume. Selling pressure is represented by stocks that close low in a range, on high volume.
Calculating the accumulation distribution line
This is the technical bit – but many trading platforms simply produce the technical tools for you so you need not worry too much about the maths.
The accumulation distribution indicator is a single line tool from the oscillator family and it fluctuates above and below a zero (0.00) level. There are three steps to calculating the accumulation distribution line.
The money flow multiplier (MFM), also known as close location value, compares the closing price for a given period to the range over that period and can vary in 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 and a value of -1 means the close is equal to the low of the range.
- The first step is to calculate the money flow multiplier followed by the money flow volume to create an accumulation distribution line. The accumulation distribution line rises when the multiplier is positive and falls when the multiplier is negative. It is calculated as follows: [(close - low) - (high - close)] (high- low).
- The second step is to multiply this by the volume over the period and this gives a measure of money flow volume (MFV). It is calculated as follows: MFV = MFM x Volume on the Period
- The third step is when this is added to a running total of money flow volume. This then creates the accumulation distribution line (ADL). It is calculated as follows: Accumulation distribution line = Previous Period ADL + Current MFV
A bearish divergence is when the security creates higher tops on the chart, while the indicator is giving lower tops. Source: ShutterstockAccumulation distribution indicator trading signals
The accumulation distribution oscillator is used to confirm whether a security is trending or to predict reversals. The four trade signals using the accumulation distribution indicator are:
- Bearish trend confirmation
- Bullish trend confirmation
- Bullish divergence
- Bearish divergence
Trend confirmation is straightforward. When you see the accumulation distribution line in the indicator window rising (bullish), this means that the trend is up. When the indicator window shows a falling accumulation distribution line, the trend is down (bearish).
The accumulation distribution line divergence is another very important feature of the accumulation distribution indicator. A divergence is when the price movement is contrary to the indicator movement and gives a bullish or bearish signal.
A bearish divergence is when the security creates higher tops on the chart, while the indicator is giving lower tops. After a bearish divergence, the security usually makes a rapid bearish move. The bullish divergence is the same but in the opposite direction.
Like with most indicators, it is a good idea to use other tools and methods in conjunction with the accumulation distribution indicator to enhance its effectiveness.
Use with other indicators
The accumulation distribution indicator is commonly employed to confirm the predictions of other indicators such as the relative strength index that helps traders decide if a stock is overbought or oversold. It measures the speed (velocity) as well as the change (magnitude) of directional price movements.
It is also used with the money flow index. This is a momentum indicator that measures the flow of money into and out of a security over a specified period of time. It can identify the current strength or weakness of a trend.
The accumulation distribution indicator is sometimes confused with the similarly-named Williams accumulation distribution Indicator that looks only at price and therefore fails to take into account volume.
An indicator that is similar to the accumulation distribution line is the on balance volume. Source: shutterstockOn balance volume
An indicator that is similar to the accumulation distribution line is the on balance volume. This is another volume-based oscillator that is used to measure the strength of the buying and selling forces. It measures buying and selling pressure as a cumulative indicator that adds volume on up days and subtracts volume on down days.
When the security closes higher than the previous close, all of the day’s volume is considered up-volume. When the security closes lower than the previous close, all of the day’s volume is considered down-volume.
As its signals are interpreted in the same way as the accumulation distribution indicator, the two tools could be combined into a trading strategy. The two indicators can diverge because accumulation distribution line compares the current close with the current high and current low. The on balance volume compares the current close with the previous close.
Yet because of the formula differences, these two can be used together to confirm one another. Strength in both would show signs of buying pressure. Weakness in both would show signs of selling pressure. It also allows traders to measure price and volume together and compare it against the pricing trend in the market.
Pitfalls to using an accumulation distribution chart
One of the pitfalls to bear in mind with an accumulation distribution strategy is that it might recognise a trend, but it does not take into account price gaps that may occur. If a stock's price has gapped upward but closes around the midpoint, that gap will be ignored because the accumulation distribution line is formulated using closing prices.
It also shouldn’t be used as a standalone indicator because it is hard to map minor changes in volume flows. It offers better results when used in conjunction with other aspects of technical analysis, such as momentum oscillators and chart patterns.