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| The Arms
Index (Trin) |
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!
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
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