Want to add another awesome indicator to your arsenal? Do you want to improve your understanding of the stock market? How about checking out the McClellan Oscillator. It’s one of the most popular and widely used market breadth indicators around. Sadly I have not done enough to cover it on the blog in detail.
So this post is 110% devoted to McClellan and his Oscillator! Here we go.
What Is It & How Is It Calculated?
Its name comes from its developers, Sherman and Marian McClellan, a great couple with a deep understanding of the stock market. This indicator is derived from Net Advances, which is simply calculated by subtracting the number of declining issues from the number of advancing issues.
Without getting too complicated, the McClellan is a market breadth indicator that is actually based on the Advance/Decline issues from the NYSE. It’s a smoothed indicator that tries to remove the daily noise and give an easier to use signal for traders.
Each day the indicator takes the difference between an approximate 19-day EMA (exponential moving average) and a 39-day EMA of advancing minus declining issues. This helps us establish a relative measure of broad-based market participation.
The McClellan Oscillator as a momentum indicator works in a similar way with MACD (Moving Average Convergence Divergence). Its signals can be generated using centerline crossovers, breadth thrusts and divergences.
Should You Focus on Recent or Older Movements?
When assessing any trend, recent movements should count more than older ones. That is determined by using an EMA. Here, you start by taking the data point that is most recent on the A/D line. You multiply the second most recent by a constant. Multiply the third most recent by the constant squared. After that, multiply the fourth most recent by the constant cubed. With an increase in the constant, the moving average is weighted more towards the present.
"Smoothing" is a term used by analysts to describe the weight above. For example, a "10% smoothing constant" means the current day's A/D line value is 20 and yesterday's is 90%. Remember the previous day's EMA consisted of 10% A/D line value of that day and 90% of the previous and the trend goes on.
How far back should you go when deducing a trend? There are many choices. You can go back one day or even 80,000 days. The more recent, the easier the arithmetic. That's why the McClellans thought of 19 and 39 day periods as being very practical. This makes it easy for people at different levels to analyze the market.
But enough with the geeky calculations…
How Does Market Breadth Help Me?
Technical indicators that use measures of advancing or declining stocks generally will give you some insights into the amount of participation in the current trend’s movement. This is referred to as the market “breadth.”
Unfortunately, it is still not possible to know how much was spent on stocks today as a long-term investment, and how much was spent on speculation. If more cash went to long-term investments, there are high chances the market could be overheating and thus headed for a correction.
Through the decades, many analytical minds in the industry have tried to figure out the future of the market by analyzing how stocks rise or fall en masse. The McClellan Oscillator is among the most enduring measures of market breadth. It is widely used by both amateurs and professionals.
In a raging and healthy bull market, there will be a large number of stocks making price advances. Sure, you will have a few stocks here and there that decline but overall the general market is advancing on a broad scale.
On the other hand, a weak market will see only a very small number of stocks advancing (but advancing at larger prices). This gives a false indication that the market is healthy yet the underlying fundamentals tell a different story. In this case only a few stocks lead the way while the majority of stocks lag or are declining.
This type of divergence in advancing/declining issues often signals the end to the trend and of course the opposite happens in bottoming markets.
The Buy/Sell Signals
These are the two primary signals that are given by the McClellan Oscillator. A majority of traders get mixed up by them which is why most end up using the incorrectly (at least in my opinion).
You first have to understand that there are 4 “trading zones” to this indicator. On the top side, there is an overbought region between +70 and +100. Anything above +100 is considered extremely overbought. Likewise on the bottom side with -70 and -100. It is important to get this right so as to make wise trading decisions.
If the M.O. falls to -90 and turns back up a short term buy signal is generated. However, if the indicator slams through the -100 level then it actually signals the start of a new downtrend and you shouldn’t be buying. This is where some traders fall into a deep and painful trap.
In up-trends the same came be said. If the M.O. climbs to +90 and turns over a short term sell signal is generated. Again, if it continues past the +100 level then a new bull market move is starting and you shouldn’t be selling just yet.
What Do You Think About Divergence?
Time for some community engagement.
As with nearly all momentum and breadth indicators, I believe divergence plays a very important role in identifying solid signals. I don’t use the McClellan Oscillator as a stand-alone indicator. I find it better to pair it up with RSI and Stochastics to get more meaningful alerts while watching for clear signs of bullish/bearish divergence.
That’s just what I think and how I do it. What do you think about using this indicator with divergence? Has it worked or not worked for you in the past? Add your comments to this post and share your opinion.