Although indexes can tell you what the overall market is doing, they can’t drill down and reveal more information. They can’t tell you how many assets are participating in a rally or pull back.
They can’t show how many are moving in the opposite direction of the market.
That’s why there are market breadth indicators like the Arms Index.
Overview of the Arms Index
The Arms Index is usually referred to as the Short-term Trading Index (TRIN). This is because it works best in day trading.
TRIN was developed in 1967 by Richard W. Arms, Jr. He wanted a technical study that could measure the impact of both rising and declining stocks. But he also wanted something that would take volume into consideration. TRIN was his answer.
TRIN is based on the Advance-Decline Index. This indicator, usually known as the AD line, evaluates the number of rising and falling assets in an index. The difference between the two is known as “net advances.”
But TRIN goes one step further. It compares net advances to the twin volumes of both groups of stocks—gainers and losers.
TRIN is an oscillator, which means it’s especially good to use when an index shows no definite trend. The indicator will generate buy and sell signals in oversold and overbought areas.
How to Calculate TRIN
The method of calculating TRIN is pretty straightforward:
- For each candlestick, determine the AD ratio. This is done by dividing the number of rising assets by the number of falling assets.
- For the same candlestick, calculate the AD volume. To do this, divide the volume from rising stocks by the volume from the retreaters.
- Divide the first calculation (the AD ratio) by the second (the AD volume).
In equation format, it looks like this:
You’ll want to plot each TRIN value below each candlestick or OHLC bar it was calculated for. Then connect the dots to see how TRIN adjusts with changes in volume and price action over time.
Of course, it will be easier just to let a good computer program do this for you. But at least now you know how the software does it.
Why the Arms Index Is Important
A traditional index like the Dow 30 only gives you a small snapshot of what the market is doing. Market breadth tools like the AD line go one step further. They look at which assets are advancing and which ones are retreating.
TRIN takes one more step by comparing the net advances to volume. Volume in this situation is crucially important. Price movements resulting from high volume have more significance than those that are linked to low volume.
So TRIN gives you a more complete picture of what is actually happening inside of an index. With a more thorough assessment, you’ll get better predictions of price action. In fact, TRIN’s values are buy, sell, and hold signals.
How Traders Use It
TRIN’s value will be below 1.0 if the denominator (the volume part of the equation) is larger than the numerator (the AD ratio). If the AD ratio is higher than the volume ratio, then TRIN will be above 1.0.
A figure below 1.0 usually coincides with rising price action. In this case, above-average volume in the advancing equities expands a rally.
Similarly, a ratio below 1.0 oftentimes coincides with declining price action. This is because above-average volume from equities that are dropping in price strengthens a selloff.
And finally, when you get a reading of 1.0, the market is considered to be in a neutral territory.
Traders generally take anything under 1.0 to be a buy signal. Conversely, a number above 1.0 is a sell signal. The further away you get from neutrality, the stronger the bulls or bears are on that day.
However, if TRIN gets too far away from 1.0, it’s a sign that the market may soon reverse. A number above 3.0 or below 0.5 could be a sign of an imminent reversal.
Trading Examples Using TRIN
Let’s now take a look at a few examples of the Arms Index in use. In the chart below, we see an intra-day chart of the S&P 500 index using 5-minute candles.
Around 10:20 am, we see TRIN reach a value of roughly 1.05, which is a mild sell signal. Sure enough, the price action starts moving downwards. This is indicated by the first brown vertical line.
About 20 minutes later, we see TRIN hit a low point, about 0.75. This is marked by the second vertical brown line. A buy signal is generated here, and sure enough, the price action begins an upward trend.
For a two-day price chart, take a look at these 5-minute candlesticks on the Nasdaq Composite Index.
Below the volume, we once again see the Arms Index. Notice how the reading is above 1.60 near the close of business on March 26th. This is a stronger sell signal than we see on the previous chart.
And clearly, the price action does reach a high near this time. Then it drops substantially at the next day’s market open. A buy signal is generated in the Arms Index, and the price action rises.
- An oscillator that gives buy and sell signals.
- Incorporates volume.
- Easy to read.
- Separates advancing assets from declining ones.
- Not all software programs have the Arms Index.
- The formula can give false readings in some situations.
- Needs to be used with other indicators.
- Other technical issues like 52-week events and support and resistance aren’t considered.
The Arms Index is an effective tool if you want to analyze what really is driving market movements. It incorporates volume and distinguishes between advancing and declining assets. Thus, you get a better idea of where an index is headed next.
But the formula can also produce readings near 1.0 in times of significant bullish sentiment. It’s a ratio; so this can happen if the numerator and denominator have similar values.
Be sure to use TRIN in conjunction with other indicators to try to get consistent trade signals simultaneously.