THE ARMS INDEX (TRIN) INDICATES WHEN THE MARKET IS DEEPLY OVERBOUGHT/OVERSOLD

Overbought -- A market that has gone up too far, too fast.
Oversold -- A market that has declined too much, too quickly.
Overbought and oversold markets present excellent trading opportunities because the pendulum is eventually apt to reverse and "swing" sharply the other way.

Measures of overbought and oversold that I discuss frequently in this newsletter include stochastics and RSI. Both indicators are based on a stock's price in relation to its own trading range. However, a separate class of overbought/oversold indicators exists. These are based on the overall performance of the market itself -- more specifically, its breadth and volume. The indicator I'm going to focus on in today's issue is "The Arms Index," or Trin.

The Arms Index is named after its designer, Richard Arms. It is also known as "Trin," which stands for the "Trading Index." The Arms Index compares two of the markets key "internals." The first is the relation of advancing issues to declining issues (stocks up at least a penny on the day versus stocks that have declined at least a penny.) Meanwhile, the second is the relation of advancing volume to the declining volume (the total volume of all stocks that closed higher on the day versus the total volume of all stocks that closed lower).

To assist you in understanding how the Arms Index is calculated, let's take a look at a recent example. Below you will find the relevant figures for all trading on the NYSE (New York Stock Exchange) on Thursday, March 11th:

Advancing Issues:  783
Declining Issues:  2542
Up Volume:  254 million shares
Down Volume:  1,612 million shares

The Arms Index is calculated using the following formula:
(Advancing/Declining Issues) / (Advancing/Declining Volume)

So, in the case of this example, the calculation would go as follows:

Advancing/Declining Issues:  783/2542 = 0.371
Advancing/Declining Volume:  254/1612 = 0.157
Arms Index Calculation:  .371/.157 = 2.35

The Arms Index for the day of Thursday, March 11th was 2.35. What the number 2.35 tells us is that far more volume went into the stocks that were declining than into stocks that were advancing. If the two ratios had been proportionate, then the Arms Index would have come in at 1.0. An Arms Index reading of 2.35 indicates that on this day there was very heavy selling pressure in stocks that moved lower.

Since individual daily readings can be quite volatile, the Arms Index is generally displayed as a 10-day simple moving average plotted on a scale. When this 10-day moving average falls below 0.80, the market is considered to be overbought. When the moving average reaches 1.20, the market is said to be oversold. The Arms Index tends to remain in this 0.80 to 1.20 range the majority of the time.

You'll usually find the Arms Index plotted alongside the New York Stock Exchange (NYSE) Index. Since that index contains every stock listed on the exchange, it is seen as the best proxy for that overall market. (You can also calculate an Arms Index for any other market, such as the Nasdaq Composite.)

As the chart below shows, the Arms Index has given an oversold signal on only seven occasions since March 2003. Meanwhile, it has not been overbought even once in that time period!

Chart provided courtesy of www.decisionpoint.com

On Thursday, the 10-day moving average of the Arms Index closed at 1.61. That is the third most oversold reading we've seen in the last year. It is also approaching the 1.8 level that marked the launch of the bull market last March. Such an extreme reading, when combined with numbers I've already discussed in my overall market analysis, indicate to me that the market should shortly experience a very strong snapback rally. This rally started on Friday.

This snapback rally will not contradict the important technical damage that has already been done. The S&P and Dow Jones Industrials have broken key support areas. Meanwhile, the Nasdaq has broken down out of its symmetrical triangle pattern. However, what it does say is that a violent snapback rally -- most likely fueled by strong short covering -- is likely to take prices back to key resistance areas in the coming days.

After several days of a near-vertical drop, the bulls may be ready to rise up in Arms.

Good trading!

Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader

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