Understanding market demand and supply using the Accumulation distribution indicator (ADI)
TL; DR
Traders can use the accumulation distribution indicator to predict price reversals.
The ADI indicates the relationship between the price of an asset and the number of sellers and buyers in the market.
The ADI is very effective during sideway markets.
During an uptrend the ADI can generate false signals, thus it is not effective.
Introduction
There are different categories of indicators such as oscillators and volume indicators which measure various trading aspects. Volume indicators, like the accumulation distribution (AD) indicator, show whether or not most traders support existing trends. In this article, we focus on the accumulation distribution indicator since it is popular.
What is the Accumulation Distribution Indicator?
The Accumulation Distribution Indicator, created by Marc Chaikin, measures the cumulative inflow and outflow of money in an asset. It achieves this by comparing the closing price with the asset’s highs and lows, which it weights using trading volumes.
It indicates whether the market is accumulating or distributing the asset which helps to predict future price movements. Thus, the indicator analyzes the asset’s trading volume and its price. By doing this, it measures the supply and demand of the asset in the market.
The accumulation distribution indicator is a single line that moves up and down on the bottom of the chart.
Accumulation and distribution indicator- Trademo
As observed on the diagram, the blue line below the candlestick pattern is the accumulation distribution indicator.
Understanding accumulation distribution indicator
Accumulation is a period when the price of an asset is rising and many traders purchase it. Most of the investors hold it, anticipating further price increases. On the other hand, distribution is a period when the price of the asset is falling and many investors sell it.
Calculation of accumulation distribution indicator
There are three key steps to follow when calculating this indicator. You need to calculate the money flow multiplier, money flow volume, then establish the accumulation distribution line.
STEP 1: Calculate the Money Flow Multiplier (MFM) using the formula, [(close – low) – (high – close)] / (high – low)
STEP 2: Calculate the Money Flow Volume (MFV) using the formula, MFM x Volume for the Period.
STEP 3: Use the total of Money Flow Volume to create the Accumulation Distribution Line (ADL).
ADL = Previous ADL + Current Period’s Money Flow Volume
How to use the Accumulation distribution indicator
The major use of the accumulation distribution indicator is to show the dominant market force during a given period. There are times when selling pressure is more than buying pressure and vice versa.
If the ADI is rising it means that there is more buying pressure in the market, thus there is accumulation. On the contrary, if the ADI is decreasing it means that there is more selling pressure in the market and there is distribution.
Accumulation and distribution- Trademo
In the above diagram, point A indicates distribution taking place while point B shows accumulation. Basically, traders buy the asset when the ADI is rising and sell it when it is falling.
Also, a positive number which is closer to +1 indicates a strong bullish momentum. On the contrary, a negative number shows a high selling pressure.
Divergences
Divergences are important as they indicate possibilities of trend reversals. As a fact, divergence occurs when the price of the asset is moving in an opposite direction as the indicator. For example, if the indicator is rising, the price will be falling.
Bullish divergence
There is bullish divergence if the price of the asset is making lower lows while the indicator is registering higher lows. Alternatively, the indicator may make higher highs while the price records lower highs. This shows that soon there will be an upward price reversal.
Bullish divergence – Alphaexcapital
As you note in the diagram, soon after the bullish divergence the price of the asset started rising.
Bearish divergence
A bearish divergence forms when the price is rising and the indicator is falling. This indicates a weakening momentum which may lead to the decrease in prices. The following chart indicates an ADI bearish divergence.
ADI bearish divergence- Alphaexcapital
As you notice on the chart, soon after the divergence the price started to fall.
Confirmation of trends
The ADI is very instrumental in confirming market trends, helping traders to tell when to enter and exit trades on time. A rising ADI shows an uptrend while a falling one confirms a downtrend. As a result, trend following traders find this indicator to be very important. This is because they will always buy the asset when the ADI is rising and sell when it starts falling. By doing this, they ride the entire trend.
Trend following trading- Daytradetheworld
The trader can open a long position at point A and ride the trend until the price reaches point B, where he/she closes the trade.
Accumulation and distribution during range market
The ADI is one of the indicators which traders can use in both trending and ranging markets. If the ADI starts rising it is an indication of accumulation, implying that there may be an upward breakout.
ADI in a range market- Estradinglife
As the diagram indicates, there was a range market between 19 August and early October. When the ADI rose in early October, the price followed suit.
If the price starts falling during a range market, it shows that the price may fall in the near future. As such, the traders may need to exit their positions.
Advantages
The ADI enables traders to identify trading opportunities in dips and rallies. It shows clear indication that the market is accumulating or distributing.
The divergences can help the traders to detect price reversals on the right time, assisting them to spot trade entry and exit points on time.
The ADI can show market changes in different time frames, increasing chances of success and reducing potential risks.
It works well with supply and trading zones as it can easily track changes in the market.
Limitations of ADI
The ADI is a tool used for confirming trends rather than indicating trading actions on its own. Therefore, traders should only use it alongside price action.
After divergences, the expected changes in price may not take place. For instance, an uptrend may not follow an ADI bearish divergence.
Conclusion
The accumulation and distribution indicator tracks the price of an asset and the number of buyers and sellers in the market. By understanding the changes in the selling pressure and buying pressure, traders can spot trade entry and exit points. However, it is important to combine ADI with price action to get the best indications.
