How to Day Trade using the Accumulation Distribution Indicator
What is the Accumulation Distribution Indicator
The accumulation distribution indicator (A/D) is an instrument which gives information about the money flow in a stock. The word “accumulation” refers to how much equity of the stock is bought. Contrary to this, the word “distribution” refers to how much equity of the same stock is sold.
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In this manner, the A/D is a volume based indicator.
The A/D is a single line tool from the oscillator family. The accumulation distribution Line (ADL) fluctuates above and below a zero (0.00) level.
This is an image of an accumulation distribution oscillator. See that the line can fluctuate quite rapidly, which, is a result of the indicator reacting to the trading volumes of the security.
Traders use the A/D indicator to validate trade entries and exits.
Accumulation Distribution Calculation
The calculation of the A/D consists of three formulas - money flow multiplier (MFM), money flow volume (MFV), and ADL.
The first formula involved in the calculation is the MFM:
MFM = ((Close – Low) – (High – Close)) / (High – Low)
Then we need to calculate the MFV:
MFV = MFM x Volume on the Period
Lastly, we have the ADL:
ADL = Previous Period ADL + Current MFV
Let’s now walk through an example:
Close = $650.00
Low = $648.00
High = $651.00
Volume on Period = 9,500
Previous Period ADL = 180,000
Let’s now add the values to the formulas:
MFM = ((650 – 648) – (651 – 650)) / 3
MFM = (2 – 1) / 3
MFM = 0.3333
MFV = 0.3333 x 9500
MFV = 3,166.35
ADL = 180,000 + 3,166.35
ADL = 183,166.35
Let’s now visualize it:
In other words, when you apply the parameters used in this example, this is how the ADL prints on the chart. Now see what happens if we add 10 more values to our calculation.
These are the values:
And now, let’s visualize it!
This now looks more like the real thing, right? The point is that the A/D determines these values based on the high, low, close, and volume of the respective period. In this manner, volumes and volatility are crucial for the technical performance of the tool.
4 Trading Signals Using the Accumulation Distribution
There are two basic signals created by the A/D tool. These are the trend confirmation signal and divergence.
ADL Trend Confirmation
The trend confirmation signal is very easy-to-understand. It also consists of two types:
1) Bullish ADL Trend Confirmation
The bullish trend confirmation signal comes when the A/D line increases during high volumes. This means that a great amount of money flow is being accumulated. This is likely to cause an increase in the price of the security.
2) Bearish ADL Trend Confirmation
The bearish trend confirmation signal comes when the A/D line decreases during high volumes. This means that a great amount of money flow is being distributed. In this manner, the respective security is likely to decrease in price.
These two signals are crucial for the success of the A/D oscillator. Traders use them to set entry and exit points on the chart in order to hop into emerging trends and to exit in the right moment.
The ADL divergence is another very important feature of the accumulation/distribution indicator. There are two types of ADL divergence based on their potential:
3) Bullish ADL Divergence
To get a bullish ADL divergence we need to identify a couple things on the chart. The first thing you need is a bearish price action. The second thing is an increasing ADL. These create a strong bullish signal on the chart.
4) Bearish ADL Divergence
To get a bearish ADL divergence we need to identify exactly the opposite situation. The first thing you need is a bullish price action. The second thing is a decreasing ADL. These create a strong bearish signal on the chart.
On Balance Volume vs. Accumulation Distribution
An indicator which is considered similar to the ADL is the On Balance Volume (OBV). This is another volume-based oscillator, which is used to measure the strength of the buying and selling forces.
It pretty much looks the same way as the A/D and the signals it gives are interpreted the same way. In this manner, the two tools could be combined into a trading strategy.
However, the two indicators could sometimes diverge. The ADL could move upwards, while the OBV could move downwards.
So, why would the two indicators diverge if they are both volume based?
The answer to this question is due to the differences in the formulas of these indicators. The ADL compares the current close with the current high and current low. The OBV compares the current close with the previous close.
The potential divergence between the two tools could create a very lucrative trading opportunity. It is very important to use the trading volumes in this situation. If the volumes are high, then the price action is likely to create a big candle on the chart.
But, the real question is what direction will the stock go after the divergence emerges?
Well, the volume indicator could provide the answer to this question.
Check out if the stock is trending first. If it is, then have a look at the volume indicator. If the volumes are high, then the trend is valid. In this manner, the divergence between the ADL and the OBV should be traded in the direction of the trend.
Here we have a classic divergence between the OBV and ADL. The two lines cross creating a divergence. Fortunately, the trend is bearish and is confirmed with relatively high trading volumes. Therefore, we get a bearish signal on the chart.
Accumulation Distribution Trading System with the OBV
Let’s now discuss the trading rules involved when trading with the ADL versus the On Balance Volume:
ADL & OBV Trade Entry
Enter a trade when you get a matching signal between the two indicators, accompanied by higher trading volumes.
This also concerns the divergence between the two indicators. You should enter an ADL OBV divergence trade, when the two indicators contradict during high volumes. In this case you enter in the direction of the trend.
ADL & OBV Stop Loss
Make sure you always protect your trades with a stop loss order. After all, this type of investing involves volatile trading on high volumes, which in many cases happen on margin (all you day traders out there).
Well, you want to be protected in these trading scenarios.
To determine the right place for your S/L order, you should use the price action rules. If you are entering a long trade, you should find a support prior to the trade signal. Then you place your stop loss underneath. If you are going short, you do the exact opposite; find a resistance level established prior to the signal and place your stop order above this level.
Profit Targets using the ADL and OBV
If the ADL and the OBV are increasing on high volumes, you should hold your long trade.
If the ADL and the OBV are decreasing, then you should be short for the same period of time. However, if the indicators change their attitude during your trade, you need to close your trade and take your profits.
Another approach is to adjust your stop when you see opposite signals on the chart.
Accumulation Distribution Strategy Example
Now let’s approach a strategy which will combine these rules into a complete trading system.
We have the 2-minute chart of Amazon from August 26, 2016.
The chart starts with a range from the leftmost side. The ADL and the OBV indicators are concentrated in the upper area. Suddenly, the price begins to decrease.
At the same time, the two indicators decrease as well while volumes are increasing. The decrease of the indicators gives you a short signal on the chart. The increasing volumes are used to confirm the validity of the signal. Therefore, we short AMZN.
The stop loss for this trade should be placed above the last resistance prior to the price decrease. This stop loss area is highlighted with the red horizontal line on the chart.
After we sell AMZN, the price begins to decrease. The drop is so strong that the stock even gaps down 4 periods after we enter the market.
In the middle of the bearish trend, the two indicators enter a range phase. We outline the levels of the range with the two black lines in the area where the indicators are plotted.
At the same time, the volumes are decreasing as well. Then the two indicators start increasing and the A/D line breaks the upper level of the range. At the same moment, the price action creates a bigger bullish candle. We can use this candle to exit our short trade. See that the price switches directions afterwards.
Let’s now review a trading example of a divergence between the ADL and OBV indicators:
Above you see the 2-minute chart of Oracle from Aug 22, 2016. The image shows a contradiction between the accumulation/distribution and the OBV.
After a drop, the price attempts to enter a bullish trend. The two indicators have been moving toward each other until they cross.
The interaction (green circle) is represented by the red and the green lines in the indicator area. At the same time, the trading volumes have been increasing.
Since the price is attempting to enter a bullish trend, we trade in the bullish direction. We open a long trade right after the crossover of the two indicators.
The stop of this trade should be placed below the bottom created at the beginning of the trend reversal. The location of the stop is shown with the red horizontal line.
The price increase continues afterwards with increasing volumes.
Suddenly, Oracle explodes in a bullish direction. The increase is rapid and is contained by only two candles. At the same time, the two indicators also increase and reach relatively high values. Then the ADL and the OBV start dropping, which is shown in the red square.
While the indicators are beginning to fall, the volume also has a dramatic drop. This is the signal we were waiting on for confirmation to exit our trade.
- The accumulation distribution is a volume based oscillator.
- It consists of a single line, which fluctuates above and below a zero level.
- The accumulation distribution Calculation consists of three formulas:
- MFM = ((Close – Low) – (High – Close)) / (High – Low)
- MFV = MFM x Volume on the Period
- ADL = Previous Period ADL + Current MFV
- The 4 tips to trade signals using the Accumulator Distribution Indicator are:
- Bullish Trend Confirmation
- Bearish Trend Confirmation
- Bullish Divergence
- Bearish Divergence
- The three important rules to trade with the ADL and the OBV are:
- Open a trade when you find matching signals. Open a trade in the direction of the trend if the two indicators contradict (diverge, cross) during high or increasing volumes.
- Place a stop above/beyond a support/resistance level created prior to the signal.
- Stay in the trade as long as the two indicators are supporting your trading decision.