Stock exchanges around the world give out the number of shares that 'advanced' or 'declined' in a trading day from the last close.
For example, the exchange may inform that out of the 7000 stocks, 4500 stocks advanced while 2000 stocks declined. The balance 500 stocks remained 'unchanged'.
The advance/decline ratio is calculated by dividing the number of advancing stocks by the number of declining stocks.
Values higher than 1 show that more issues are presently advancing than declining.
Values between 0 and 1 indicate that more issues are currently declining in price.
Stock market indexes are very tricky. For example, it is possible for the Sensex to report a gain at the end of the day in spite of many stocks falling, if a couple of heavyweight stocks in the index do well. In such cases, stock indices may not give you that actual picture of what's happening. To get the real picture, you need the number of shares that advanced and declined out of the total number of shares listed. If too many stocks have advanced it gives us an indication that we are in a bull market.
Another way you can use the advance/decline numbers is in watching trading during the day to spot trends or false trends. For example, if a major index is up significantly, but you find that there is no corresponding increase in advance numbers. So, that increase could be a bubble in a major stock that's going to burst.
If the broad based index conflict with the advance/decline numbers, you have to go with the numbers (and not with the index) to determine what the market really did in terms of direction.
One of the major limitations of the advance/decline numbers is they don't tell you anything about the size of the advances or declines. It just tells the numbers. It doesn't tell whether advances were up a Rupee or a 100?
Advance/decline is a very simple and effective indicator. It gives you an indication of how the overall market is doing and can add a level of information to indexes for a better understanding of they mean.