In last Thursday's column, we looked at how breadth and depth can give you early warnings of a new trend. By "breadth," we simply meant volume. For any new trend to be sustained, there has to be at least steady - if not growing - volume. Similarly, the majority of stock issues have to be moving in the same direction for "the market" to move in that direction. This is called "breadth." Having one or the other, quite frankly, isn't really enough if you're looking for the big trends. You really want to see both components in place, and as we saw, the breadth and depth of the New York Stock Exchange was not quite in place. The NASDAQ's breadth and depth looked a little more compelling, but had its own problems as well. If you missed that column, you may want to review it here before going any further, since today's column builds on the same idea.

Now, the reason we wrote that column was partially to set up this one. Hopefully we at least sold you on the idea of watching volume and the advance/decline data. If not, we'll just reiterate that this information (especially volume) is one of the best tools a trader has when it comes to spotting a trend shift before it's well underway.

But there is an easier way. You don't have to gather four pieces of data, and then plot moving averages of each one and wait for crossovers for both sets. There is a single-line indicator that incorporates all the same data, and is just as useful as well as just as accurate. It's called the Arms Index (named after the developer Richard Arms), but you may have heard it called by it's more common name - TRIN. That's short for "TRading INdex."

Like the advance/decline and volume data, the TRIN indicator is exchange-specific. For today's illustration, we'll be using the NYSE data to calculate our TRIN. You can also find TRIN readings for the NASDAQ and AMEX exchanges, but we've found those two TRIN readings to be a little too volatile to use effectively. We'll stick with the NYSE for right now.

Before we get into what TRIN is, just keep in mind the philosophy of how we apply this information; it's going to look a little bit different than what we saw on Thursday's charts. What we're looking for here is balance. If the bullish volume is twice as strong as the bearish volume, that's ok as long as the advancers are twice as numerous as the decliners. Everything would still be proportional. If the advancers outnumber the decliners by a 2 to 1 ratio, but there is heavier volume on the selling side of the market, clearly things are out of whack - and that's when reversals occur. So now, let's define TRIN and see how it's used (and then we'll look at why it's particularly troubling right now).

As described above, the TRIN is a comparison of advancing/declining issues and the advancing volume/declining volume. It was designed by Richard Arms to highlight points in time when there is an imbalance in the advancers/decliners and the underlying trade volume of those advancers and decliners. We're using the advancing/declining data for the New York Stock Exchange, but a TRIN reading can be calculated for any of the exchanges. The formula is as follows:

(# of Advancing Stocks / # of Declining Stocks)          = ARMS INDEX
(Volume of Advancers / Volume of Decliners Stocks)      

All things being equal, a perfectly balanced Arms Index would be 1.0. If the advancers or decliners become disproportionate with their corresponding volume, the Arms Index deviates from 1.0. Of course, the market always eventually finds its natural balance, so when the TRIN levels are highly skewed, we know a big reversal is probably in the works. Note that the TRIN reading can stay at 1.0 while the market is crashing or while bullishly running away; all the Arms Index is designed to do is point out an imbalance in the advancers/decliners and the volume behind those advances and declines. TRIN does not necessarily pinpoint the direction of a chart. This is - needless to say - the key different between Thursday's study and the TRIN indicator.

An Arms Index above 1.0 indicates that the volume in declining stocks outpaced the volume in advancing stocks. An index reading of up to 1.2 is still considered normal in a declining market. An Arms Index reading below 1.0 indicates the volume in advancing stocks was healthy and outpaced the volume in declining stocks. An index at the 0.85 level is still considered to be a sign of normal, healthy growth. It's when the TRIN readings start to fall outside of these ranges (above 1.3 and below 0.8) when the trend is getting ready to shift in the other direction. Oh yeah, one more thing - the daily TRIN readings are still too erratic to use by themselves. What we're using here is a 12-day moving average of the TRIN day. You'll soon see why this makes the tool much easier to use.

On the top of our chart we've plotted the S&P 500 and a 20-day moving average. On the bottom of the chart you'll find the daily TRIN readings in faint gray. Like we said, the raw data is too erratic to use to spot a trend. To smooth out the data and put it into a useful form, we've applied a 12-day moving average (in blue). The two dashed lines on the TRIN chart are plotted at 1.3 and 0.85.....the extremes that often are reached right before a reversal. Even just a brief glance over the last few months will illustrate how powerful this tool is. Three of the last for times the 12-day TRIN average fell under 0.85, the market soon took a big tumble. Conversely, the last three times that the 12-day TRIN average reached 1.3 or higher, a rally was ignited.  The sell signals are marked with red arrows, while the buy signals are marked with green arrows.

S&P 500 with 12-day average of TRIN

The worry we partially voiced on Thursday is much more stark here. The 12-day TRIN average just bounced back above a reading below 0.8. This is usually a setup for a downside move, as we've seen more than once in the last several weeks. They may not always take effect immediately. So, it's not surprising to see the indexes making lower lows and lower highs after making some topping patterns at the end of last week. Just food for thought, and another tool to put in your war chest.

Price Headley is the founder and chief analyst of BigTrends.com.