When reporters talk about what
the market did at the end of the day, they generally report three
leading market indices: the Dow Jones Industrial Average, the Standard
and Poor's 500 Index and the NASDAQ Composite Index.
The Dow Jones Industrial Average was created more than 100 years ago
when it was difficult to make complex computations of stock prices.
For this reason, it consists of only 30 blue chip stocks that
represent the best companies of American big business. People refer to
the Dow as the market. Initially, it was concentrated
in industrial stocks. However, with time, and as technology companies
grew very rapidly, the Dow average has gradually lost its "smokestack"
bias.What drives the Dow Jones
Industrial Average?
Because it was created before computers were invented, the Dow index is
computed very simply. Originally, Charles Dow created this index by
adding prices of 30 stocks and dividing the result by 30. Over the
years, the divisor, which originally was 30, became smaller because of
stock splits and the changing of the components in the average.
However, the Dow Jones Industrial Average is still computed in the
same way it was more than 100 years ago.
Because of the way it is computed, the index is a price-weighted
average. As a result, the largest companies have the largest influence
in the index. General Electric is one of the most influential stocks
in the Dow, and, therefore, changes in General Electric stock have a
large impact on the size of the change in the Dow Jones Industrial
Average.
What drives the Standard and Poor's 500
Index?
Another popular index is the S&P 500, and it's computed by weighting the
market capitalization of the stocks listed in the index. As a result,
companies with large market values, such as General Electric, Cisco
and Microsoft, have the biggest influence. The S&P 500 contains 500
stocks chosen by Standard and Poor's, which is a unit of McGraw-Hill.
The stocks included in this index are the leading companies in all
U.S. industries. The S&P 500 has a heavy representation of large
international, steady-growth companies.
Because of the features of the S&P 500, it tends to mirror the action
of the stocks of large companies.
What other influences are there on the
market?
Other more specialized indices measure sectors of the market. You can
find these sub-indices on any financial page of a daily newspaper.
Although the three indices previously
described in this article do not represent "the market," they are a
good proxy for what is happening in the marketplace. The purpose of
technical analysis is to understand their action and have a sense of
the likely direction of the market. To gain this kind of
understanding, however, other information is necessary.
At the end of each day, several statistics are made available to
investors about the action that took place on the New York Stock
Exchange or the NASDAQ. For example, the number of stocks that have
advanced during the day, the number that have declined and the number
that were unchanged (in other words, those that exhibited no price
change from the closing of the previous day to the closing of the
current day).
Other important data are the trading volume
of advancing stocks, trading volume of declining stocks and total
trading volume that took place on a particular stock exchange.
Two of the most important technical indicators that paint a picture of
the market's movement are the subject of the remainder of this
article. For simplicity's sake, I'm using the Standard and Poor's
index to show how these measures can help you derive more information
about the action of the market and whether the market is at a high or
low risk level.
Moving Averages
When one looks at the price
action of the market, it is very difficult to establish its trend
because of the jagged pattern of the price during a week or month. One
of the most used techniques for smoothing the price action of stocks
is moving averages.
A moving average is a way of averaging the price. The outcome derived
— a smooth line — provides information on the direction of the market.
There are two types of moving averages. A
simple moving average obtained over a period of, let's say 20 days, is
obtained by adding the market value of 20 days and dividing the
outcome by 20. The following week, the new week is added, and the
first week is dropped out of the average. The total obtained is once
again divided by 20.
Moving averages tend to lag the action of the
market. This is the "price" that investors have to pay for the
smoothing effect of the moving average. The use of moving averages is
twofold. The first important use is as a visual aid for determining
the trend of the market.
So, why use Moving Averages (and
how, and when)?
Remember that Moving Averages
track the trend of prices. They don’t forecast; they shed light on
what prices have been and are doing. Thus, they can provide you with
decision support in knowing when to get in and out of a market. They
work best in trending markets, which is why the oscillator comes in
handy for choppy or sideways markets.
And, as with all indicators, the decision support Moving Averages
provide is strengthened by their use with other, complementary
indicators.
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