How to Trade Stocks Using Summation Index

Traders use technical tools to spot directional changes in the stock market.

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Among the favorite tools of technical stock market traders are the McClellan Oscillator and the McClellan Summation Index. Developed in the 1960s by Sherman and Marian McClellan to attempt to detect market direction, they were originally figured using the number of advances and declines on the New York Stock Exchange, but the process has since been applied to use the advances and declines on Nasdaq and other exchanges to predict their directions.

McClellan Oscillator

The basis for the Summation Index, the McClellan Oscillator, is derived by taking the difference between the advance and decline figures on the NYSE or other exchange for two periods of time -- 39 days and 19 days -- and averaging each list to create a moving average. The final step is to subtract the 19-day average from the 39-day average to obtain the oscillator. It gives an indication of the market directional trend over the 39 days with modifications by more recent market movements, smoothed out to counteract temporary spikes. Smoothing is a way of removing the effect of temporary spikes that might give an unreliable idea of where the market is going.

Summation Index

The McClellan Summation Index, or MSI, is an indicator of the long-term directional movement of the market, made up of the intermediate-term indications produced by the oscillator. It further smooths temporary market movements to define the true longer-term trend. Take the previous day's MSI figure and subtract the current oscillator to arrive at the current MSI. It is considered useful because it isn't price-based but direction-based, so it isn't influenced by market capitalization, as is the Dow Jones Industrial Average.

Use of Oscillators

When subtracting declines from advances, the resulting number can be negative or positive, and the same applies when subtracting the 19-day results from the 39-day results. The buy or sell signal occurs when the oscillator crosses the zero-line, indicating an intermediate-term trend in the market. Although the oscillator smooths out temporary movements, it still can give false signals and might be more appropriate for quick in-and-out trading.

Market Signals

The MSI serves to further smooth out the oscillator and identifies the real longer-term market trends. It is effective in revealing the developing market trends and major directional changes in the market. For example, the Dow might be in what appears to be a strong rally, but the continued rise in the Dow is often due only to price rises on a few stocks that have big market capitalization, while most of the stocks are declining in price. The same thing can happen when most of the stocks are rising in price but, due to the influence of a few large-capitalization stocks, the Dow shows an overall market decline. Use the MSI to follow the underlying directional trends. Many traders add a five-day moving average of the MSI to verify buy and sell signals when the MSI crosses above or below the five-day moving average.