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TRADERS INDEX AND OTHER STOCK MARKET INDICATORS
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The Traders' Index (TRIN) is a leading stock market indicator. It shows when major rallies and declines get ready to reverse by measuring the inten­sity of optimism of the dominant market group. Excessive optimism is associated with market tops and excessive pessimism with bottoms.

TRIN measures the ratio of advancing to declining stocks and compares it to the ratio of advancing to declining volume. This indicator was popularized by Richard Arms and is included in most quote systems. Any broker with a terminal on his desk can punch a few keys and see the latest TRIN. It is easy to calculate TRIN by hand or by using a computer at the end of each trading day.

New market developments have changed TRIN over the years: listed stock options, index arbitrage, dividend recapture plays, and so on. The original interpretation of TRIN had to be adjusted, but TRIN continues to stand out as one of the best stock market indicators. It helps in timing stock trades as well as trades in stock index futures and options.

How to Construct TRIN

You need four pieces of data to calculate the Traders' Index: the number and volume of advancing and declining stocks as well as the volume of both groups. These figures are released by the New York Stock Exchange and several other exchanges throughout each trading session.

TRIN = Adv Issues Adv Volume / Decl Issues Decl Volume

TRIN compares the relationship between the ratio of advancing and declining stocks and the ratio of advancing and declining volume (see worksheet, Figure 38-1). If 1000 stocks rally on a volume of 100 million shares, and 1000 stocks decline on a volume of 100 million shares, then TRIN equals 1. If 1500 stocks go up on a volume of 150 million shares and 500 stocks go down on a volume of 50 million shares, TRIN remains 1.

TRIN falls when the volume of advancing stocks is disproportionately high, compared to their number. TRIN rises when the volume of declining stocks is disproportionately high, compared to their number.

The position of NH-NL in relation to its centerline shows whether bulls or bears are in control. When NH-NL is above its centerline, it shows that more market leaders are bullish than bearish. Then it is better to trade the stock market from the long side. When NH-NL is below its centerline, it shows that bearish leadership is stronger, and it is better to trade from the short side. NH-NL can stay above its centerline for months at a time in bull markets and below its centerline for months at a time in bear markets.

5. If NH-NL stays negative for several months but then rallies above its centerline, it signals that a bull move is likely to begin. Then it is time to look for buying opportunities, using oscillators for precise timing. If NH-NL stays positive for several months but then falls below its cen­terline, it shows that a bear move is likely to begin. Then it is time to look for shorting opportunities using oscillators for precise timing.

More on NH-NL

Old analysts used to smooth NH-NL using 10-day and 30-day simple mov­ing averages. When a 10-day MA of NH-NL crossed above a 30-day MA, it gave a buy signal. When a 10-day MA crossed below a 30-day MA, it gave a sell signal. Raw NH-NL gives clearer signals, but if you still want to smooth NH-NL, it is better to use exponential moving averages.

The number of new highs and new lows is reported daily by the New York Stock Exchange, the American Stock Exchange, the Over-the-Counter Exchange, and the London Stock Exchange. Most overseas stock exchanges do not report these numbers, but a computer-equipped analyst should have no difficulty creating NH-NL for any market. Traders who use NH-NL outside of the United States get an edge over competitors who lack this indicator. You need to obtain one year's worth of daily data for every stock on the exchange you follow and update that file daily. Program your computer to examine your database each day and flag those stocks that have reached a new high or a new low for the past 52 weeks.

NH-NL does not work in the stock markets dominated by a handful of stocks. For example, hundreds of stocks are listed on the Milan Stock Exchange in Italy , but only 2 of them — FIAT and Generale — represent nearly 70 percent of total market capitalization. These two giants can override the rest of the market.

The volume of advancing stocks often swells out of proportion to their number during rallies. If the ratio of advancing to declining issues is 2:1, but the ratio of advancing to declining volume is 4:1, then TRIN equals 0.50 (2/1 + 4/1). A low TRIN shows that bulls are highly optimistic, a rally is being overdone, and a top is near.

When the market falls, the volume of declining stocks often swells out of proportion to their number. If the ratio of advancing to declining issues is 1:2, but the ratio of advancing to declining volume is 1:4, then TRIN equals 2 (1/2 + 1/4). A high TRIN shows that bears are too optimistic, too much volume goes into the declining stocks, a decline is being overdone, and the market is nearing a bottom.

TRIN can change sharply from day to day. TRIN gives better signals when it is smoothed with a moving average. You can use a 13-day exponen-

tial moving average of daily TRIN (see Section 25). It filters out the noise of daily swings and shows the true trend of this indicator. For the rest of this chapter, the term TRIN is used as shorthand for 13-day EMA of daily TRIN.

Plot TRIN on an inverted vertical scale. Low numbers on the top identify market peaks, and high numbers at the bottom identify market lows. Two horizontal reference lines mark overbought and oversold levels. When TRIN rises above its upper reference line, it shows that the stock market is overbought and nearing a top. When TRIN falls below its lower reference line, it shows that the market is oversold and nearing a bottom.

The level of reference lines depends on whether the stocks are in a bull or bear market or a neutral trading range. The overbought line is usually placed at 0.65 or 0.70 in bull markets, 0.70 or 0.75 in bear markets. The oversold line is placed at 0.90 or 0.95 in bull markets, 1.00 or 1.10 in bear markets. These levels may shift by the time you read this book—use them as a starting point for your own research.

The best way to draw reference lines is to examine a chart of an index such as the S&P 500 for the past six months, along with TRIN. Mark all important tops and bottoms of the S&P 500 and draw two reference lines that cut across the corresponding tops and bottoms of TRIN. When TRIN enters those extreme areas again, you will know that the market has entered a reversal zone. Adjust oversold and overbought lines every three months.

Crowd Psychology

The stock market is a manic-depressive beast —it swings from expansive mania to fearful depression. The mood of a manic-depressive patient goes through cycles. When he reaches the bottom of depression, his mood starts to improve. When he rises to the height of mania, he starts to slow down. Traders can use TRIN to diagnose manic and depressive episodes in the stock market and bet on their reversals (see Figure 38-2).

Crowds are emotional and short-term oriented. Trends often go farther than you expect because crowds act out their feelings and run instead of acting rationally. Trends reverse when masses of traders get tired of running. TRIN shows when they become exhausted.

If bulls become greedy during a rally, they buy so many shares that advancing volume swells out of proportion with the number of advancing stocks. When TRIN rises above its upper reference line it shows that mass optimism has risen to a level associated with tops.

If bears dump shares during a decline, then downside volume swells out of proportion with the number of declining stocks. When TRIN falls below its lower reference line, it shows that bearishness is being overdone and an upside reversal is near.

Changes of TRIN are similar to what happens during rush hours at a suburban commuter train station. In the morning, the departure platform gets overcrowded, while at night there is a crowd at the arriving platform. The biggest crowd identifies the peak of the trend — either into the city or back home. You can identify traffic reversals by measuring the number of com­muters crowding a platform. That is what TRIN does in the stock market.

TRIN identifies rush hours in uptrends and downtrends. It flags bullish extremes at stock market tops and bearish extremes at market bottoms. TRIN identifies mood swings of the stock market crowd. Professionals use this information because they tend to trade against deviations and for a return to normalcy.

Trading Rules

TRIN is plotted on an inverted scale. High numbers mark the bottoms and low numbers signal market tops. TRIN hovers between 0.75 to 0.85 in neu­tral markets. It is less than 1.0 because the volume of advancing stocks normally exceeds the volume of declining stocks. People are normally more bullish than bearish.

TRIN cannot be used mechanically — the same readings mean different things under different market conditions. Overbought and oversold readings are lower during bear markets and higher during bull markets. For example, TRIN of 0.60 marks great bullish strength at an early stage of a bull market. It tells you to look for every opportunity to add to long positions. The same read­ing of 0.60 during a rally in a bear market marks a major shorting opportunity. This is why it pays to adjust overbought and oversold lines every three months.

•  Buy when TRIN leaves its oversold zone. When it crosses above its
lower reference line, it shows that bears have run out of steam. Buying
at this time is like betting on a traffic reversal after the rush hour.

•  Sell when TRIN leaves its overbought zone. When TRIN sinks below
its upper reference line, it shows that bulls are running out of breath.
Selling short at this time is safer than trying to pick the exact top.

•  TRIN works best when combined with the New High-New Low
Index (see Section 37). If TRIN becomes oversold while NH-NL
reaches a new low, it shows that bearish leadership is strong and the
downtrend is likely to continue. If TRIN becomes oversold but NH-

NL traces a bullish divergence, it marks an important low. The combined signals of TRIN and NH-NL give traders confidence to buy a larger position.

4. If TRIN becomes overbought but NH-NL rises to a new high, it shows
that the upside leadership is strong and the uptrend is likely to con­
tinue. If TRIN becomes overbought while NH-NL traces a bearish
divergence, it often marks an important stock market top. Then you
can short a larger position.

TRIN gives its strongest buy and sell signals when it diverges from prices.

•  When the stock market rises to a new high but TRIN traces a lower
peak than it did during its previous rally, it shows that bulls are losing
power. When bulls cannot purchase as many shares as before, the
uptrend is in trouble. A bearish divergence between TRIN and the
stock market gives a strong sell signal.

•  When the stock market falls to a new low but TRIN flattens out at a
more shallow level than during its previous decline, it shows that bears
have fewer stocks to sell. When bears start losing power, the market is
ready to rally. A bullish divergence between TRIN and the stock mar­
ket gives a strong buy signal.

More on TRIN

The New York Stock Exchange releases information on advancing and declining stocks and their volume throughout each trading session. Intraday TRIN can be used by day-traders.

TRIN can be applied to any stock exchange that reports the numbers of advancing and declining stocks and their volume. When that data becomes available for overseas exchanges, the first traders to use it will have a competitive advantage.

Advance/Decline

The Advance/Decline line (A/D line) measures mass participation in rallies and declines. If New Highs and New Lows are the officers, and the Dow

Jones Industrials are the generals, then the A/D line shows whether or not the soldiers are following their leaders. A rally or decline is more likely to persist when the A/D line rises to a new high or falls to a new low in gear with the Dow.

To calculate A/D for each day, subtract the number of declining stocks from the number of advancing stocks and ignore unchanged stocks. The result is positive or negative, depending on whether more stocks advanced or declined. For example, if 1900 stocks were traded, 900 advanced, 700 declined, and 300 were unchanged, then Advance/Decline equals +200 (900 - 700). Each day's Advance/Decline figures are added to the previous day's total, creating a cumulative A/D line.

Traders should keep an eye on new peaks and valleys in the A/D line because its absolute level depends mostly on its starting date. Broadly based rallies and declines have greater staying power. If a new high in the stock market is accompanied by a new high in the A/D line, it shows that the rally has broad support and is likely to continue. If the stock market reaches a new peak but the A/D line reaches a lower peak than during the previous rally, it shows that fewer stocks are participating, and the rally may be near its end. When the market falls to a new low but the A/D line traces a more shallow bottom than during the previous decline, it shows that the decline is narrow­ing down and the bear move is nearing an end. These signals tend to precede reversals by weeks if not months.

Most Active Stocks

The Most Active Stocks indicator (MAS) is an advance/decline line of the 15 most active stocks on the New York Stock Exchange. They are listed daily in many newspapers. Several large capitalization stocks, such as IBM, frequently appear on this list. Other stocks make the list only when they catch the public's eye due to an extremely positive or negative piece of news. MAS is a big money indicator — it shows whether big money is bullish or bearish.

MAS for each day equals the number of the most active stocks that advanced minus the number of the most active stocks that declined. For example, if 9 of the most active stocks went up, 4 fell, and 2 were unchanged, then MAS for that day is 5 (9 - 4). Each day's MAS is added to the previous day's total, creating a cumulative MAS line.

When MAS moves in the same direction as the broad stock market, it

shows that big money supports the trend and it is likely to continue. When the market goes one way and MAS goes the other way, it shows that big money is betting on a reversal. When the trend of MAS diverges from the price trend, the market is especially likely to reverse.

Other Stock Market Indicators

Only a few stock market indicators have withstood the test of time. The New High-New Low Index and TRIN are probably the best stock market indicators, followed by Advance/Decline and Most Active Stocks.

Old stock market books are full of fascinating indicators, but you have to be very careful using them today. Changes in the market over the years have killed many indicators.

Indicators based on volume of low-priced stocks lost their usefulness when the average volume of the U.S. stock market soared tenfold and the Dow rose sixfold. The Member Short Sale Ratio and the Specialist Short Sale Ratio stopped working after options became popular. Member and specialist short sales are now tied up in the intermarket arbitrage. Odd-lot statistics lost value when conservative odd-lotters bought mutual funds. The Odd-lot Short Sale Ratio stopped working when gamblers discovered puts.

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