High Low Index or Breadth Indicator is the index that compares the stocks that hit their 52-week highs with the stocks hitting their 52-week lows. By this comparison, this index helps the market participants to validate the current stock market trend. Or, we can say it is a useful tool to gauge the strength and weakness of an underlying index or market status. It is a market sentiment indicator.
Also, it may serve as a useful trading indicator that reflects the past data because it considers fluctuating averages of the new highs and lows. Traders and analysts use this indicator in their technical analysis.
High Low Index – Calculation
The index is a simple moving average based on record highs and record lows. In other words, it is usually a 10-day simple moving average of the recorded high percentage. But, one could use a longer period as well. So the length of the time period varies from person to person or purpose.
The underlying index that we use for its calculation is usually the index that is a good representation of the whole market, such as the S&P 500 and more. So this index effectively calculates the moving averages of the new 52-week highs as well as 52-week lows of the stocks that constitute that index. It calculates the average using the Record High Percent method.
So, we need to first calculate the Record High Percent. And that represents the percentage of new highs to new highs and lows.
Record High Percent = (New Highs)*100/(New Highs + New Lows)
The next step is to calculate a 10day simple moving average for index calculation. To get the 10-day simple moving average of the Record High Percent, we need to add the Record High Percentages of the last ten days and then divide the resultant number by ten.
A point to note is that since this index is a moving average, with every passing day, the data of the farthest day is replaced by the most recent data. Also, to take out the impact of extreme volatility in the index, the calculation averages the Record High Percentages. This helps to bring out a better picture of the index movement.
How to Interpret?
The Breadth Indicator tells if the underlying index is in a bullish state or a bearish state. Generally, the market is said to be in a bearish state if the prices drop by 20% or more from the peak. And the market is said to be in a bullish state if the prices go up by 20% or more from the bottom.
Suppose the Breadth Indicator is more than 50. This would mean there are more stocks with 52-highs than with 52-week record lows. And, if the index score is less than 50, then there are more stocks with record 52-week lows.
Also, if the index score remains consistently around the 70 levels, then the underlying index is deemed to be bullish. On the other hand, if the score is consistently around 30, then the underlying index is deemed to be bearish.
High-Low Index and Market Efficiency
By now, we well understand that the Breadth Indicator is quite useful to know and appreciate the relative robustness or weakness of the underlying index. But, whether or not one can use it to generate buy or sell signals is debatable.
There is an old proverb and standard disclaimer used in the investment world. It is that the “past performance is not a guarantee of future returns.” So all analyses and indicators one needs to take with a pinch of salt. Still, this Breadth Indicator is quite useful in technical analysis. As basically, technical analysis is the concept where based on past historical data, one attempts to predict and suggest the likely trend and outcome in the future.
Yes, the index can help in predicting future performance. But, this will only hold if we assume that the market is not weak-form efficient and could lead to adverse outcomes.
When we talk of market efficiency, then there are three common forms. And those are:
So, an investor needs to believe that the market is not in a weak-form efficient state to act on the buy/sell signals generated from Breadth Indicator. However, such an assumption may not hold good in the real world.
Trading with High-Low Index
Many traders use the index score to generate buy and sell signals despite the unlikely assumption. However, such traders do not rely only on 10-day averages and generally add a 20-day moving average of the index. The buy signal is when the index rises above its moving average, and the sell signal is when the score is below the moving average.
However, traders must not solely rely on this index. Instead, use other technical indicators as well to back their decision. For example, along with the buy signal from the index, a trader may use the RSI (relative strength index) to confirm the upward or downward movement.
The Breadth Indicator is a pretty accurate and useful indicator of the strength and weaknesses of an underlying index. Traders may also use it to generate buy or sell signals, but they must not solely depend on it. Instead, use other technical indicators as well to confirm the buy or sell signal from the Breadth Indicator.