By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com
The technical indicators that are generally aimed at specific stocks, which were discussed in previous sections, can also be used on market indexes. However, there is also a series of indicators, which were formulated specifically for gauging the direction of the major market indexes and are not used to analyze individual securities.
The main difference between market indicators and technical indicators is that market indicators are not plotted on the same chart as a security but are plotted on a chart by themselves. The market indicators do not reflect just one security but a large array of securities in the market and vary from measuring market sentiment to the current volatility in the market.
The volatility indexes (VIX) are used to gain an understanding of the amount of volatility in the market that the index tracks. It is based on the movements and expectations in the market. To many traders' surprise, it is possible to trade market volatility and each of the main volatility indexes can actually be bought or sold on a regulated exchange.
These indexes are traded on the Chicago Board Options Exchange where the VIX tracks the S&P 500, the VXN tracks the Nasdaq 100, and the VXD tracks the Dow Jones Industrial Average.
Each of the volatility indexes are calculated by using the implied volatility of a relevant mix of put and call index options. This gives a good idea of the perceived risk in the market from participants, with the higher the volatility index value the higher the perceived risk.
In general, the volatility index and the index itself tend be negatively correlated by moving in the opposite direction. When everything is going good in the market and prices are rising, the perceived risk is at its lowest. When the market is moving lower the perceived risk is at its highest.
These volatility indexes are used to identify points in the market where participants are either overly bullish or bearish. When the volatility indexes are at recent highs while the market is down it is a positive signal that the market is too bearish. When the volatility index is extremely low and the market is high it suggests that there is too much bullishness in the market and is a negative sign. (For more on this subject see, Getting a VIX on Market Direction and Introducing The VIX Options.)
One of the most well known and used market breadth indicators is the advance-decline line, which compares the amount of securities that trader higher for the day in the market compared to the amount of securities down for the day.
The total number of companies trading higher is subtracted by the number of declines and the total is then cumulated to create the advance-decline line. For example if yesterday's advance-decline total was 100 and there were 5 more advances then declines the advance-decline total would go from 100 to 105.
This market indicator is used to signal reversals in the market trend by looking for divergence. This happens when the advance-decline line is moving in the opposite direction of the market. The advanced-decline line reversal tends to precede market reversals when there is a divergence after a long period of both the indicator and the market moving in the same direction.
This market indicator measures the breadth in the market by using the number of advances and declines to form moving averages, which are then used in conjunction with each other to calculate the indicator.
The McClellan oscillator is calculated by taking the difference between the 19-day and the 39-day exponential moving average of the net of advances and declines in the market. The differences are then plotted over time against a centerline. When the oscillator is at the centerline, which is the zero level, it means that the two averages are equal.
When the oscillator is above the centerline it means that the 19-day moving average is above the 39-day moving average and suggests that advances are moving ahead of declines. If the oscillator is below the centerline it means the 19-day moving average is below the 39-day moving average and suggests that declines are moving ahead of advances.
Market buy-and-sell signals are formed when the McClellan oscillator crosses over the centerline. When it crosses in an upward direction a buy signal is formed and sell signal is formed when the McClellan oscillator crosses in a downward direction.
McClellan Summation Index
The McClellan summation index expands on the McClellan Oscillator by using the oscillator to focus on longer term trends in advances and declines. This is done by creating a running total of the McClellan oscillator in the same way the advance-decline line was created.
This index is generally thought to fluctuate +/- 1,000 of the centerline which is zero.
This measure is thought to give more accurate signals of market tops and bottoms and is a useful measure of the markets strength. A market top will generally be signaled when the McClellan summation index is extremely high (over 1,000) and a market bottom will be formed when it is extremely low (under 1,000).
Shifts from a bull market to a bear market are often represented by large rapid shifts in the summation index. A new bull market signal is formed, for example when the summation index goes from -900 to +900 within a matter of months.
Arms Index - TRIN
The Arms index or TRIN (Traders Index) is another market breadth indicator used to evaluate the health of the overall market. It compares advances and declines along with the volume behind the advances and declines.
The Arms index is calculated by taking the number of advances and dividing it by the number of declines. That number is then divided by the volume of the advances by the volume of the declines.
The number shown on the Arms index chart is a moving average of the numbers calculated in the Arms index, which helps smooth the data. The length of the moving average is adjusted to reflect the length of the user's outlook: short, intermediate or long term.
The moving average is plotted against a centerline of one. When the Arms index is at one, the market is considered to be neutral as the ratio of advances to declines equals the ratio of advancing volume to declining volume. Buy-and-sell signals are formed when the Arms index is at extremes. Sell signals are formed when the index moves towards three to four and buy signals are formed near zero.
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