Many traders are confused when the question comes to the indexes. In many cases novice traders do not bother by index analysis simply because they are focused mainly on stocks analysis. The truth is that the indexes reflect the general sentiment of the stocks from this index basket and if you trade C (City) stock it is essential to analyze DOW (^DJI) index. If you trade MSFT (Microsoft) stock it is recommended to keep an eye on the Nasdaq 100 index. If the index based technical analysis suggest that its market sector is going to be Bearish, most likely a stock you trade will follow general trend even if your stock trading system generates opposite signal.
By embedding index based technical indicators into a stock trading system a trader may substantially improve the trading system he/she uses.
A simple rules could be set on the results of the index technical analysis and applied to the stock trading system. Basically if from the results of index analysis a trader has knowledge of the current market sentiment he/she can make more informative desertion about buying or selling a considered stock. As an example let's take a look at simple trading rules that uses results of the Nasdaq 100 index technical analysis. These rules could be applies to the trading system that was build to trade MSFT stock:
If technical analysis applied to the NASDAQ 100 index shows higher odds of the bull market then:
Rule #1. If trading system generates "Buy MSFT" signal (the same direction as the result of the NASDAQ 100 analysis direction) then a trader may consider buying the stock;
Rule #2. If technical analysis applied the MSFT contradict to the results of the Nasdaq 100 index analysis then a trader may consider staying in cash and waiting when both analysis (index analysis and stock analysis) points in similar direction
If technical analysis applied to the NASDAQ 100 index shows higher odds of the bear market then:
Rule #3. If results of the MSFT analysis predict down move (the same direction as NASDAQ 100 direction) then a trader may consider selling the stock;
Rule #4. If trading system generates "Sell MSFT" signal (opposite direction to the results of the NASDAQ 100 analysis) then a trader may consider staying in cash and waiting when both analysis points in the same direction
Basically, by summarizing the rules above we could set two simple rules for stock trading system that uses elements of the index technical analysis:
It is logical to have index analysis included into each stock trading system. By knowing the general market direction a trader should not be surprised why his/her stocks drops when all technical indicators applied to that stock pointed that it should be higher. If the market crashes down most likely your stock will be down as well.
By using index analysis in a stock trading system a trader can more safely trade the market, avoid uncertain trades, and manage how much to invest into a trade.