Applying Technical Analysis on an index (discussion)This is a topic that keeps coming back into my mind. I am a believer in and user of TA, but the concept of applying it to indices keep haunting me. I googled it and found a few YouTube videos that did nothing to help. So I decided to put my thoughts down on paper.
Here’s the thing, using the S&P500 as an example. In an uptrend, we know that the market in general is moving up. And vice versa in a downtrend. We also know that the S&P500 consists of 500 large companies, each with a life, business, earnings and share price movement of their own. Recently, a handful of tech companies have taken charge, accounting for about 35% (MotleyFool, July 2024), but that leaves 65% to the others. So how is it that technical analysts use their tools to predict the movement of an index, then it clearly has no direction of its own?
Technical traders will look at support and resistance levels, directions, pullbacks, indicators and so on to try to predict future behavior. They will place their trades based on this. On stocks, commodities, FX. And on indices.
And here’s my quarrel with myself: an index is a derivative, it is 100% dependent on the movements of the underlying assets, which in fact IS the index. An index has no will or movement of its own, it moves as the underlying moves. Again, using the S&P500 as an example, it is the combined movement of 500 stocks that move the index. If the S&P500 is approaching a level of resistance, that should be irrelevant. The index is like a puppet on a string, it has no influence of its moves. In theory, ALL of the 500 companies making up the index might not be near resistance (not likely, but in theory). So, the idea of an index bouncing off resistance makes no sense, it all depends on the action of the underlying assets. Yes, as Mag7 make up 35% of the index, their behavior weighs heavy, but in terms of TA for the index that does not matter. If all of them should happen to also meet resistance, there is still 65% of the index that might not be.
In essence, TA should not work on an index. On a stock, traders make a direct impact on price and thereby charts, they are seamlessly connected. For an index, there is no such direct connection, it is through a number of underlying components, 500 of them in the case of S&P500.
However, we know that TA is heavily used on indices, and sometimes actually work as well. Just to mention, I know you can trade indices “directly” via i.e. futures and CFDs, but these are derivatives of the index (which itself is a derivative...), and as such has no impact on the price or direction of the actual index. Statements like “the S&P500 is approaching a strong level of resistance, so we might see a pullback” puzzles me. The only way the S&P500 can experience a pullback is if the majority of the components, in terms of value, also experience a pullback. The index has no movement of its own, it has no free will.
So why does it work? Before we dive into that, I must say that I mainly look at trend and general direction when trading indices. I rarely even consider support and resistance or any other factors. I sometimes look at the strength of a movement, but again any strength is dependent on the underlying, and so indicators i.e. applied to an index is of limited value as I see it.
Why TA might work on indices is a complex topic, and there is no correct answer. One theory is that (still using S&P500 as example) when the S&P is approaching a level of resistance, it can make investors anxious. If they are long NVDA, MSFT, F, WMT, they might think they should sell or reduce their position. “The market is expected to pull back, better take profit, I can buy back after”. If enough investors do this, the index will do just as predicted. Also, if the market is making ATH after ATH, more people will want to get onboard, pushing the index even further.
In closing, I looked at the 5-year chart of the S&P500. You must look really hard to find definitive levels of support and resistance, as can be seen from the chart. I would argue there are none. No levels being touched several times, no clear levels of bounce either up or down. Trend is present, but considering what I have discussed above, is this index related? Or is the index simply moving as the underlying is moving? Clearly the latter, as an index has no direction of its own.
I am sure there are many views on this, as there should be. TA is a very subjective “science” and I expect many opposing views, especially on my last paragraph. It is highly welcome! I started this post being very uncertain what I think of TA applied to indices. As I was writing, thinking, considering, I have come closer to deciding where I stand on this.