Breadth and divergence

Breadth data has many interpretations. The conventional interpretation is to look for positive and negative divergence between breadth and index movements. Let’s take the simplest breadth indicator – the the ratio of advancing shares to declining shares (A-D ratio).

In a “normal” situation, index direction and breadth should be aligned in the same direction. When the index is up, A-D should also be up and vice-versa, both should be down. Quite often, there is a divergence however, in index direction versus market breadth.

For example, say, the Nifty has moved up. However, in the same period, the A-D ratio is adverse with more Nifty shares having lost ground than gained. Since the Nifty is market cap-weighted (like most indices), this is quite common: A few heavyweights can swing the index up even if the majority of shares lose ground.

This is negative divergence. A technician would be wary of a sudden, deep correction. It would also be a negative divergence if the bulk of shares in the broader market were down (and other broader market indices like the CNX500 were bearish) while the Nifty went up. The standard tactic is to wait for the Nifty to correct downwards, or more optimistically, for the A-D ratio to move up.

A positive divergence is the inverse situation. The Nifty moves down due to the bearish influence of a few under-performing heavyweights while the bulk of stocks in the Nifty (and maybe in the broader market) move up. In a positive divergence, the trader waits for the price to switch upwards or pessimistically, for the A-D ratio to turn negative.

This interpretation is simple. Positive divergence waits for the price to swing up. Negative divergence waits for the price to move down. There are more sophisticated ways to glean inferences from breadth and some may clash with the conventional interpretations.

Market participants can be divided into three classes – retail, domestic institutional investors (DIIs) and foreign institutional investors (FIIs). The top 200 stocks contribute close to 90 per cent of market cap. DIIs and FIIs focus on these companies because it’s not worth their while chasing gains in tiny businesses. Price moves in smaller stocks are usually driven by retail.

A low positive A-D, or a negative A-D ratio, coupled with positive price trends in major indices implies that retail is selling, while institutions are net buying. This situation can last for months without any hint of a correction. A highly positive A-D ratio and an uptrending index means retail is also buying, which is fine.

But a high A-D ratio coupled with a falling Nifty can often mean institutional selling is being coupled with retail buying, which is definitely not a positive divergence. The smart analysts will disaggregate the breadth data segment by segment, sector by sector to identify these situations.

The author is a technical analyst