Technical Indicators: A Primer

If it betters its previous overbought reading, the momentum is intact. If it turns down shy of the previous peak, we conclude momentum is waning and label that a negative divergence. It says to be cautious in here.

The best way to use this indicator, though, is for positive and negative divergences. If the market is rallying and the Dow peaks around the same time it becomes overbought, then we must conclude that it is simply overbought and must look for some weakness to begin buying again.

However, after the oscillator swings back down to oversold territory and rallies once again toward overbought, we can once again look for the peak of this rally. If the Dow subsequently makes a new high and the oscillator does not, that is a negative divergence. It tells us the momentum on this rally is not as strong as the previous rally. It says to be cautious in here.

If, on the other hand, the Dow fails to make a new high but the oscillator surpasses its previous overbought level, we know that there's still underlying strength and that stocks should be bought; there is still momentum left in the market.

The same holds true for declining markets, where the tendency is for a market to become oversold.

Cumulative Advance/Decline Line

Also known as market breadth, this is the cumulative total of advancing issues minus declining issues on the New York Stock Exchange each day. It is a good guide to what individual stocks are doing. If this indicator is making new highs each day, then we say the rally is widespread and consider that a positive. If this indicator is lagging, then we say that the rally is narrow and would consider that a negative for the market.

This indicator is not to be used as a timing tool, as it can peak many, many months before the rest of the market.

This column was originally published on RealMoney on January 23, 2002 at 2:49 p.m. ET. It was republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.