Trading using the arms index

November 28, 2015 01:00 PM

The Arms Index (also known as TRIN, an acronym for TRading INdex) was developed in 1967 by Richard Arms. This volume-based indicator determines market strength and breadth by analyzing the relationship between advancing and declining issues and their respective volume. The Arms index is used to measure intraday market supply and demand, and it can be applied over short or long periods, though it is primarily used as a short-term trading tool.

The Arms Index is calculated by dividing the number of stocks that advanced in price by the number of stocks that declined in price to determine the advance/decline ratio. Then the volume of advancing stocks is divided by the volume of declining stocks to determine what is known as the upside/downside ratio. Finally, the advance/decline ratio is divided by the upside/downside ratio.

Here are the steps:

TRIN = ADR / ADVR, where

ADR = Number of advancing issues / number of declining issues
ADVR = Volume of advancing issues / volume of declining issues

Advancing Issues is simply the number of stocks that closed higher on the day and declining Issues is the number of stocks that closed lower. Advancing volume is the summed volume of all advancing issues, while declining volume is the summed volume of all declining issues.

The advance/decline ratio portion of the equation also is known as simply the A/D ratio. Likewise, the second part of the equation is known as the A/D volume ratio.

Once calculated, the Arms Index is plotted as a time series beneath price (see “Tracking breadth,” below).

Interpretation

The Arms Index is primarily a short-term trading tool. The Index shows whether volume is flowing into advancing or declining stocks. If more volume is associated with advancing stocks than declining stocks, the Arms Index will be less than 1.0; if more volume is associated with declining stocks, the Index will be greater than 1.0. 

As you might expect, when the Arms Index is below 1.0 (when more volume is associated with advancing stocks), it’s considered bullish. When the Arms Index is above 1.0, it is considered bearish. A strong up day for an index will push the Arms Index down, and a strong down day will push the Arms Index up. 

A reading of 1.0 is a neutral point, and the indicator moves above and below it. Whenever the Arms Index is near 1.0, that means the market is at equilibrium and “all bets are off.” In other words, trading should be avoided.

Usually a reading below 0.5 indicates that a short-term top in price may be in place or close at hand, and a reading above 2.0 indicates a short-term bottom in price may be in place or close at hand.

In actual usage, the Arms Index seems to work most effectively as an overbought/oversold indicator. When the indicator drops to extremely overbought levels, it is foretelling a selling opportunity. When it rises to extremely oversold levels, a buying opportunity is approaching.

Trading using trin

We can use the S&P 500 chart shown earlier to demonstrate the overbought and oversold analysis of the Arms Index. As illustrated in “High and lows” (below), which charts the index from February 2015 to July 2015, a reading of 2.0 or higher indicated a short-term bottom was close at hand and the price was due for at least a bit of upside movement.

This played out in March and June. Traders following the Arms Index during these months would have been able to capture short-term bottoms in the S&P 500.

As shown in “Nasdaq reacts” (below), which charts the tech-heavy index during the same February-July period, readings of 0.5 or lower corresponded to short-term tops in the market, and price was due for at least a bit of downside movement.

In practical trading application, consider using oversold levels on the Arms Index to confirm entry points during an overall uptrend. Define the uptrend using a 200-day moving average. Look for the Index to reach 2.0 or higher to signal an oversold level in the price. Enter long as soon as the price starts to show strength again and the TRIN reverses back below 2.0.

As shown in “Bullish bounce” (below), the NYSE revealed a good long entry setup in February 2014 when the index traded down toward its 200-day moving average and the Arms Index surged to around 3.0. A reasonable, low-risk stop on this trade would have been set just below the 200-day moving average.

The same approach can be applied during a downtrend. Wait for rallies in price where the Arms Index reaches 0.5 or below. Once the price begins to move higher, or the Arms Index moves above 0.5, look to enter a short position with a stop loss just above the recent high.

The Arms Index also can be used to confirm breakouts in stocks. Ideally, when the price breaks higher, the Arms Index should be below 1.0 to show there is buying pressure (but not below 0.5, as that would indicate the price may be overbought). Buy when the price breaks above the pattern.

The chart “Breakaway” (below) shows IBM breaking above a descending triangle pattern. Just prior to the breakout, the Arms Index was below 1.0, showing buying pressure, and at the point of breakout the Index was right near 1.0. This provided enough confirmation of the buying pressure to trade the breakout. This confirmation could have been used to enter a long position. Breakouts that occur in the direction of the overall trend are more likely to be profitable.

The same concept applies to downside breakouts. Look for an Arms Index that is above 1.0 just prior to or at the time of breakout. Again, the breakout also should be in the direction of the overall trend.

Trin limitations

Overbought and oversold levels are not exact. The Arms Index can move well beyond these extremes before a price reversal occurs. Also, just because an overbought or oversold level is reached doesn’t mean the price will reverse.

The Arms Index, as described here, is predominantly a short-term indicator, used by day traders and swing traders. It can be used as a longer-term indicator if the data are smoothed and averaged, say over four, 21 or 55 periods. This can be done by applying a moving average to the indicator, and then focusing on the moving average reading. Spikes will be smoothed out over a number of days and only the strongest overbought and oversold readings will appear in this moving average of the Arms Index.

Given that it is primarily a short-term indicator, it is best to use the Arms Index in conjunction with overall trend analysis. The method for isolating the broader trend is up to the trader, but using a 200- or 100-day moving average can aid in objectively establishing trend direction.

As is obvious in the charts, the Arms Index can have erratic movements and therefore may not be an ideal indicator to use for exiting profitable positions. The strategies discussed here focus on establishing a trade with a trending move; once that trend move is in place, another method must be employed to exit the position with a profit.

Using the Arms Index, or TRIN, can be a useful part of any active day (and swing) trader’s toolkit of indicators when used properly. It provides immediate market breadth and long/short bias that can be used to improve discipline and directional trading entry skills.

About the Author

Bramesh Bhandari is a proficient stock trader at Indian stock market.He share his insight in Forex,Commodity and World Indices through his site http://www.brameshtechanalysis.com. He also provides online tutoring on technical analysis to traders.He can be reached at bhandaribrahmesh@gmail.com.