Technical indicators help us analyze stocks to know how to trade them, but they focus on the external price action of individual stocks. While this is not bad in itself, knowing the general market sentiment is equally important. This is where the Arms Index comes in. But what is the index about?
The Arms index or short-term trading index (TRIN) is a market sentiment indicator that helps gauge the internal strength or weakness of a market. It compares the number of increasing and decreasing stocks (AD Ratio) to the increasing and decreasing volume (AD Volume).
At the end of the article, we make a backtest of a TRIN Arms Index trading strategy. Let’s get going.
What is the Arms Index (TRIN)?
The Arms index or short-term trading index (TRIN) is a market sentiment indicator that helps gauge the internal strength or weakness of a market. It compares the number of increasing and decreasing stocks (AD Ratio) to the increasing and decreasing volume (AD Volume). The indicator is seen as a measure of market velocity and mass because it factors in both the increase and decrease in price and volume.
It is used to know the general direction of the market. Arms Index is an oscillator-type technical indicator that is basically used to spot short-term extreme conditions in the market. It does this by comparing increasing and decreasing stocks (also known as the AD Ratio) and increasing and decreasing volumes.
When the indicator shows 1.0, it usually indicates equality between the AD Ratio and volume. It means that the market is in a state of balance because the up volume is spread evenly over the increasing stocks and the down volume is spread evenly over the decreasing stocks.
As a popular view, most analysts see the Arms as bullish when the reading is below 1.0. This is because the volume of the average up stock is greater than the average down stock. As a matter of fact, the indicator has been found to be in a long-term balance below the 1.0 line. This is an indication of a continuous bullishness of the stock market.
However, when the indicator reading is greater than 1.0, it is seen as having a bearish bias because the volume of the average down stock is greater than the volume of the average up stock.
Furthermore, if the indicator is significantly greater than 1.0, it means there’s a big difference between long and short positions for the trading day. A reading of 3.0 typically indicates an oversold condition and that the market sentiment is dramatic. It could mean a bullish reversal is imminent. Whereas a reading below 0.50 is seen as overbought conditions and the bullishness might cool down.
As a trader, you should not only look at the reading of the indicator but monitor its changes throughout the day. It is important to take note of market extremes because they indicate a turning point in the market.
Who created TRIN?
The TRIN (Arms Index) was created by Richard W. Arms in 1967 to measure the relationship between market supply and demand. But the index only became popular in the 1970s, but it’s still popular to this very day.
The formula for Arms Index (TRIN)
Below is the general formula for the index
Arms = Increasing Volume/Decreasing Volume/Increasing Stocks/Decreasing Stocks
Increasing Stocks = Sum of up stocks for the day
Decreasing Stocks = Sum of down stocks for the day
Increasing Volume = Sum of up volumes of all up stocks
Decreasing Volume = Sum of down volumes of all down stocks
How to calculate the Arms Index (TRIN)
The Arms indicator is available on most trading platforms. However, to calculate it by hand, follow the steps below:
- For a chosen timeframe, say H4 or D1 or whatever time frame is chosen, get the sum of up stocks, the sum of down stocks, the sum of volumes of up stocks, and the sum of volumes of down stocks
- Calculate the AD Ratio by diving the sum of up stocks by the sum of down stocks.
- Now, divide the sum of up volumes by the sum of down volumes, this will give you the AD Volume.
- Divide the AD Ratio by the AD Volume
- Write your result and make a plot of it.
- Repeat the above for the next trading session in your chosen timeframe.
- After that, connect multiple points on your plot to see how the Arms trend over time.
What is AD volume?
The AD (Advance-Decline Volume) Volume Line measures the breadth of the market by taking the net volume up, which is the volume of stock up minus the volume of stock down.
The AD Volume indicator is a continuous measure of Net Increasing Volume, sloping upward when the line is positive and downward when it is negative.
The AD Volume Line is plotted for a particular stock index, for example, the S&P 500 index, and used to compare the performance thereof. The line would confirm an increase or decrease with similar movements. A bullish or bearish divergence by the indicator is a sign of a reversal in buying or selling for the index.
What do advancing and declining volumes mean?
The advancing volume refers to the sum of the volumes of advancing stocks, while the declining volume refers to the sum of the volumes of declining stocks. The volume behind rallying stocks shows the buying pressure, while the selling pressure is represented by the volumes of declining stocks.
Since AD Volume measures volume, it can be considered an indicator for measuring the momentum during a rally or dip. If the AD Volume Line starts to record new highs together with the underlying index, it means there is strong buying pressure behind the momentum which is seen as a bullish sign. In contrast, if the AD Volume Line fails to confirm new highs and does not keep up with the underlying index, it is a sign of weakness in buying pressure since there is a bearish divergence between the indicator and the underlying index.
Furthermore, the market is considered bearish when the AD Volume Line starts forming new lows together with the underlying index. This indicates strong selling pressure. When there is a bullish divergence between the indicator and the underlying index, it usually means that the selling pressure is ebbing and that a reversal is near.
The AD Volume Line measures the market by taking into account the buying and selling pressure in big-cap stocks, which are the stocks with the largest volumes on major exchanges. An increasing AD Volume Line shows that more money is flowing into rallying stocks than declining stocks.
How to interpret the Arms Index
The Arms index shows three possible readings:
- When the indicator is at the 1.0 line. It means that there is an equilibrium between the AD Volume Ratio and the AD Ratio and that the market mood is neutral. The volume of the advancing stocks is the same as the volume of declining stocks, and the number of the advancing stocks is the same as that of the declining stocks.
- When the indicator is below the 1.0 line. It means that the AD volume is greater than the AD Ratio, which indicates an incoming bull market. A reading below 1.0 usually results in strength in a rally, and this is because of the rise in the volumes of stocks.
- When the indicator is above 1.0. It means that the AD Volume is less than the AD Ration and this usually signifies a bear market. An indicator reading below 1.0 indicates a strong downward pressure since the volume of decreasing stocks is increasing – meaning that the volume in the average down stock is greater than the volume in the average up stocks.
Note that the farther away from 1.00 the TRIN value is, the greater the contrast between buying and selling in that trading session. When it rises above 3.00, it indicates an oversold market and that bearish sentiment is too dramatic, so a bullish reversal may be around the corner. Likewise, a TRIN value that dips below 0.50 may indicate an overbought market, which may indicate an incoming bear market.
What does breadth mean?
Breath in the market means the number of stocks responsible for a given momentum in an index. An index may be experiencing a rally, yet more than half of the stocks in it are declining because only a few stocks have such a large move to influence the index as a whole.
Market breadth indicators can show this internal behavior and warn you that most of the stocks are underperforming, even though the index seems to be performing so well. Some of these indicators factor in volume in their calculations, which gives more insight into what is happening in an index.
TRIN ARMS index – wrapping up
The Arms index might be a very useful volume indicator as it tells you what an index is doing on the index. It shows how money is flowing in and out of a stock index. However, as with other sentiment indicators, the Arms index should not be used as a standalone indicator and it must be backtested. You might have additional confirmations by using technical indicators and chart patterns.
TRIN – Arms Index Trading Strategy – backtest
Let’s backtest the TRIN Arms Index with clearly defined settings and trading rules.
In the trading strategy backtests below we have used TRIN data from Tradestation and imported it to Amibroker, the software of our choice on this website (please read our comparison of Amibroker vs Tradestation). The data differ slightly from the definitions and calculations done above in the article. Here is a screenshot of what TRIN looks like in Tradestation:
As you can see, the TRIN index deviates but it shouldn’t alter the results from our backtests and conclusions much.
We make two TRIN strategy backtests:
TRIN – Arms Index Trading Strategy – backtest no 1
Let’s backtest the following TRIN trading strategy:
- When today’s TRIN reading is above 100, we go long the S&P 500 (SPY) at the close.
- We sell at the close when today’s close is higher than yesterday’s high.
The equity curve of this simple trading strategy looks like this (click here to read about a good equity curve):
The lower pane shows the drawdowns along the way (how to prepare and deal with drawdown). The strategy has 522 trades and the average gain is 0.39% per trade. This is not a tradable strategy as it is now so let’s make some modifications:
TRIN – Arms Index Trading Strategy – backtest no 2
We did many backtests involving TRIN, but the best results are when we add a second trading indicator to the trading rules.
When we added the second trading indicator (and kept the requirement of having a TRIN above 100) we got the following equity curve:
The average gain per trade almost doubles to 0.66%. Moreover, the win rate is pretty high at 77% (why a high win ratio in trading is important) and the profit factor is 2.4 (examples of profit factor).
It’s the combination of the two indicators that make the difference. The second indicator on its own has an average gain of 0.42%, so clearly, the TRIN adds some value to the strategy.
If you want to know the second strategy, please purchase our product where you get access to the code and plain English of more than over 125 other robust trading strategies:
TRIN Arms Index trading strategy – ending remarks
The TRIN trading indicator might be useful but most likely not on its own. In order to make a profitable TRIN trading strategy you must backtest by including some other parameters in the mix as we have shown in this article.