Accumulation Distribution Line

Accumulation Distribution Line is a volume-based indicator that shows the cumulative inflow or outflow of money for a security. 

As the name suggests, an Accumulation Distribution Line (ADL) indicates whether a particular stock is being accumulated or distributed. It is basically a cumulative indicator that uses both the price as well as the volume of the security to assess its accumulation or distribution. To do so, it identifies the disparity between a security’s price and its flow of volume.

By doing so, ADL suggests how strong a particular price movement is. For instance, if the price is on a rising trend but the accumulation distribution line is falling, then it is an indication that the purchase volume is not strong enough to provide a further support to price rise. Hence, a fall in price may be witnessed in the near future.

In other words, it can be said that the accumulation distribution line measures the supply and demand of a particular security or asset by looking at its price and volume variables.

The accumulation distribution line was developed by famous American analyst March Chaikin. Initially, ADL was named as the Cumulative Money Flow Line by Chaikin. 

What does the Accumulation Distribution Line indicate?

The accumulation distribution line indicates the impact of demand and supply factors on the price of a security. It helps market participants to first assess the trends in price and then foresee how the trend will persist in future i.e., whether it will continue or reverse. To put it simply, the volume-based indicator shows the cumulative inflow or outflow of money for a security. 

Let’s take an example to understand this.

If the price of a particular security is on a decreasing trend but the accumulation distribution line of that security is on an upward trend, then it indicates that there is a strong buying pressure for the security which may result in the reversal in the price trend in the near future, i.e. the price might rise going forward.

On the other hand, if the price of the security is on an increasing trend but the accumulation distribution line of that security is on a downward trend, it is indicative of a potential selling spree warning of a probable decline in price in the near future.

As opposed to an inverse trend, if the price and the accumulation distribution line move in the same direction, for instance both are in a downward trend, it indicates that there is still strong supply, and the prices are to continue to decline further.

Calculation of the Accumulation Distribution Line

To calculate the accumulation distribution line, the money flow volume is used. The volume is computed using the money flow multiplier and the period volume. 

Here is the step-by-step process to compute the accumulation distribution line and the formula:  

• The first step in calculating the accumulation distribution line is computing the money flow multiplier using the most recent period’s close, low and high price levels. Here’s the formula:

MFM = (Close-Low) – (High-Close)/High-Low

Where MFM = Money Flow Multiplier, Close = Closing Price, Low = Low price for the period and High = High price for the period

• The second step is to calculate the money flow volume using the money flow multiplier and the volume of the current period. The following formula is used to calculate this: 

Money Flow Volume = Money Flow Multiplier*Period Volume

• The Money Flow Volume calculated above is added to the last value of the accumulation distribution line in the following formula:

A/D = Previous A/D + CMFV

Where A/D is the value of the accumulation/distribution line and CMFV is the current period’s money flow volume

It’s important to note that for the first value of the line, the money flow volume is used itself as the value of the accumulation/distribution line.  

The above process is repeated as and when each period ends by adding/subtracting the new money flow volume to/from the previous accumulation distribution value to get the ADL indicator. 

Shortcomings of Accumulation/Distribution Line:

Like many other technical indicators and tools used by stock traders, the ADL also has its own limitations. The indicator is fraught with two main limitations:

Firstly, it focuses only on the closing price in the current period range and hence does not factor in the price changes from one period to another thereby creating some anomalies. For instance, let’s say a security gaps down 20% on a large volume. The price keeps oscillating throughout the day and finally closes towards the upper end. But, let’s say it is still down from the previous close by say 18%. This would result in the accumulation/distribution line to rise because even though the stock lost value, it closed in the upper end of the price spectrum. The indicator might in fact rise significantly due to high volume. Thus, traders need to stay wary of such anomalies as they can be somewhat misleading

Secondly, another limitation arises from the fact that the accumulation distribution line monitors divergences. Divergences are poor signals of timing. Whenever any disparity occurs between the accumulation distribution line and the price, it does not necessarily mean an imminent price reversal. The price reversal may happen after a long time or may not happen at all

In a Nutshell

Accumulation Distribution Line can be a useful tool in the hands of a market participant who is looking to draw insight from the accumulation or distribution level of a stock. However, to get more reliable inputs, it is advisable to use the indicator in conjunction with other market analysis tools like chart patterns, fundamental analysis, etc. to get a better picture.