Prices of individual stocks have a strong tendency to move in the same direction as the overall stock market. They also tend to follow the direction of other stocks in the same industry group. This effect can also work in reverse, as a single stock can affect may affect how the entire sector moves. This is especially true if the change in price is large, or the stock is among the biggest or most heavily traded in the group. The larger the market capitalization of a company, the more likely changes will affect the rest of its peer group.
Overall market conditions have a large effect on the prices of individual stocks, so awareness of the current market environment is critical for traders. Knowing the important technical levels for the major market indices and the various industry groups can be a valuable tool. Even if you don’t personally trade based on them, enough market participants do that they have a very real effect on price movements in the stock market.
Major Market Indices
Knowledge of broad market conditions gives you a bird’s eye view of the market while helping you avoid the trap of short-term noise. The Dow Jones Industrial Average is one of the world’s most widely followed stock market indexes. It measures the combined price activity of 30 of the top companies in the United States.
The companies come from a variety of different industry sectors in order to reflect a diversified view of the overall performance of the stock market. Of the many indices available to track the stock market, the Dow is popular because of its simplicity and very long history. The components of the index are changed periodically as the economy changes. The current list of Dow Jones Industrial Components includes:
Altria Group Inc
American Express Co
American International Group Inc
E.I. DuPont de Nemours & Co
Exxon Mobil Corp
General Electric Co
General Motors Corp
Home Depot Inc
Honeywell International Inc
International Business Machines Corp
Johnson & Johnson
JPMorgan Chase & Co
Merck & Co. Inc
Procter & Gamble Co
United Technologies Corp
Verizon Communications Inc
Wal-Mart Stores Inc
Walt Disney Co
Two NASDAQ Stock Market issues, Intel and Microsoft, were incorporated into the DOW in 1999. Prior to this, only stocks that were traded on the New York Stock Exchange made it into the Dow Component List. As you can see from its composition, these are no longer just “ industrial” firms. The index has changed over time to reflect the emergence of services as a major part of economic activity in the US.
Standard & Poor’s 500 Index, or the S&P 500, rivals the Dow as the most widely-followed stock market index. It is comprised of a diverse group of 500 top equities traded on US Stock Exchanges. Unlike the Dow, which simply measures the combined price movement of 30 companies, the S&P 500 is weighted by market capitalization. That means the price changes of larger companies affect the index more than that of the smaller companies. In fact, of all the major indices the Dow is the only one that is a price-weighted index.
The larger number of companies in the S&P 500 allows it to measure a broader spectrum of price activity and reflect the depth and reach of the money movement into, or out of, 500 top stocks traded across different exchanges – including the NYSE, NASDAQ and AMEX. It is also the basis of the S&P 500 Futures Contracts traded on the Chicago Mercantile Exchange. Institutions and individuals use these highly liquid futures to both speculate on the direction of the market and to hedge their equity holdings.
The NASDAQ Composite Index began in 1971 with a base value of 100. Since then the index went over 5,000 in year 2000 before dropping back to its current level around 2,300. This index tracks the combined movement of over 4,000 stocks traded on the NASDAQ stock market and includes more speculative (and volatile) stocks than the other two major market indexes. The chart below shows just how much this index has changed (percentage-wise) over the past 5 years compared to the Dow and S&P 500:
Another widely-followed market index is made up of a smaller sample of the NASDAQ Composite, the NASDAQ-100 Index (Symbol: NDX). It is a market cap weighted index that measures the combined price movement of 100 of the largest non-financial stocks traded on the NASDAQ. The NDX has a very high correlation to the NASDAQ Composite, and the two indices have historically moved in the same direction and magnitude over 90% of the time.
Below is a list of the major market indices (To add them to you Quotes Display in OptionVue 6, remember that all index symbols must be preceded by a “$” character)
INDU – Dow Jones Industrial Index
SPX – S & P 500
OEX – S& P 100
COMPQ – NASDAQ Composite
NDX – NASDAQ 100
RUT – Russell 2000
For those interested in trading the market indexes themselves, a popular choice are exchange traded funds (ETFs) which acts like mutual funds that owns the components of this index but trade like a stock. The Diamonds for the Dow Jones Index (Symbol: DIA), the Spyders for the S&P 500 (Symbol: SPY), and the NASDAQ 100 trust (Symbol: QQQQ) trade large volumes of shares every day. These all have options trading on them as well, with some of the most liquid option markets of any traded assets today.
Sector Indices and Industry Groups
While all stocks tend to move together in the same direction as the overall market, this tendency is even stronger for stocks in the same sector or industry group. Within the overall market there are periods when some sectors are stronger or weaker than others, and stocks in the same industry are even more likely to move in the same direction.
Monitoring industry groups and sectors is an important part of the analysis when considering a trade. It is important for a trader to know which industry groups are currently experiencing strength or weakness in a given time period, and you should understand how that sector or industry group typically performs in the current stage of the economic cycle.
Below are a list of broad market indices that are often used by traders to give them a useful overview of the of how the overall equity markets are performing, as well as some popular sector indices for following the individual industry components of the economy.
XAL – Airline Index
BKX – Banking Index
BTK – BioTech index
IIX – Internet Index
MSH – Morgan Stanley High Tech
XOI – Oil Index
OSX – Oil Services Index
DRG – Pharmaceutical Index
SOX – Semi-Conductor
TXX – Technology Index
UTY – Utility Index
There are also industry and sector specific ETFs available to trade as well, and many of them have options trading on them as well. Whether you are trading a single stock or an sector-based ETF you should consider checking on the news for that particular industry group each day. This is easily done on many of the major financial websites. Below is an example from MSN Money, where you can quickly scan the all the news available for a particular industry by choosing that industry from the drop-down menu:
As I often mention in my articles on fundamental analysis, financial ratios and measures are best compared with other companies in the same industry. Different industry groups will move in different directions depending on what part of the economic cycle you are currently experiencing. And companies in different industries can have very different capital needs. That means they will probably have very different financial structures.
It makes sense to follow the broader market trends, because your chances of success will be better when you are entering bullish trades in rising markets and bearish trades when the overall market is falling. By the same token, every industry group has periods when it is weaker or stronger than the market in general, and you should prefer to enter bullish trades in companies whose industry groups are outperforming the market, and bearish trades in those industries that are underperforming the market.