An argument against market direction determining your bias

I've been pondering further the question of letting the general market direction determine your trading bias, against focusing solely on the price action of stocks that you are looking to trade.

Regular readers of the blog will know that I made the decision late last year to place less reliance on what the major market averages were doing, as I was not looking to trade them. I look to trade individual stocks based on what their own price action is telling me.

Thinking about this made me delve into understanding how the index prices and movement are calculated, which meant referring to the guide on the FTSE website.(Note: I'm not that much of an anorak that I sat working through all the formulae, I was just looking at the principles of how the various indices are calculated!)

Below are the 10 stocks which have the highest weighting within the UK FTSE100*:

1	HSBC Holdings	7.11%
2	Royal Dutch Shell A	5.53%
3	BP	4.98%
4	Glaxo Smithkline	4.09%
5	British American Tobacco	3.87%
6	Royal Dutch Shell B	3.56%
7	AstraZeneca	3.34%
8	Vodafone	3.23%
9	Diageo	2.68%
10	Lloyds Banking Group	2.47%
	TOTAL	40.86%

*from latest figures available from the FTSE, based on closing prices as at 30 September 2014. Currently, there are 101 constituents in the FTSE100.

On that basis, those stocks (basically equating to only 10% of the population of the index) have a combined weighting of over 40%.

Now, as a trader, I want to put the odds and probabilities in my favour as far as possible. The question is, does blindly following the price movements or trends in the index help me achieve this?

As a trend follower, I look solely at the price action of the stocks that are showing the potential for a new trend signal. Each stock I trade is assigned a risk of 1R of my capital. I don't care what their market cap or index weighting is, whether they make widgets, drill for oil, are a bank or anything else - I look at price action. If it is a good set up which meets my criteria, then I will look to trade it, long or short.

Now, consider a situation where those 10 stocks listed above are in uptrends. The other 90% of the index constituents could all be in a downtrend. Depending on the degree of movement up or down in all those stocks and their weighting, it is possible that a small number of market constituents can determine the overall market direction. I'm reminded here of Jim Rogers' comments in his Market Wizards interview about the market action in the run up to the 1987 crash, which alludes to the same principle:

"If you check, you will see that, during 1987, while the S&P and the Dow were going up, the rest of the market was quietly eroding away."

On that basis, if 90% of the market constituents are in downtrends, and yet the market is going up, what would you do? Would you move the odds in your favour if you trade a stock in the 90% rather than the 10%?

Now think about what's been happening in the FTSE100 over the best part of the last two years - no discernible trend. Yet, there have been plenty of constituents have have trended up or down.

The scans that I use will help flag this up for me - the number of potential long or short set ups that come up each day can be a guide. You could even create a scan to simply list which stocks are above or below say their 50 day or 200 day moving averages, and then use that as a quick and dirty guide to determine your bias, which gets around the distortion created by the weighting given to each stock in an index.

To finish, here's a couple of facts and some follow up questions for you to ponder:

• The Dow Jones Industrial Average was created in May 1896, yet the New York Stock Exchange started in 1792;
• The headline index in the UK, the FTSE100 started up in 1984. It's forerunner, the FT30 started only in 1935. Yet the modern London Stock Exchange was created in 1801.

If you were a trader and tried to follow trends before the indices existed, would you have been any more or less successful in your trading by not having a major market average as a reference? 

Would the price action on the stock(s) you were trading have been sufficient? 

If they abolished the indices tomorrow, what would you do?

Some people may completely disagree with what I've put above, and that's fine. There wouldn't be a market of buyers and sellers if everyone had the same beliefs about the markets...

So, while 'top down' trading has been used very successfully by a large number of market participants, and will no doubt continue to do so, there is an argument which says it is not the only way, and in any case it may not necessarily be the best way to determine your bias.