Problems with the Arms Index
- Arms Index Components & Interpretation
- Arms Index Fundamental Problems
There are mathematical oddities with the Arms Index. To begin, the basic formula of the Arms Index is presented below:
(Advancing Issues / Declining Issues) / (Advancing Volume / Declining Volume)
According to the status quo interpretation of the Arms Index, a reading below one is bullish and a reading above one is bearish. However, what if there was a truly bullish day. For this example, twice as many stocks will be gainers on the day than will be losers. Likewise, twice as much volume was transacted with the stocks that were gainers than was transacted with the losers of the day. To recap, a very bullish day, gainers (Advancing Issues) outpace loser by a 2 to 1 ratio, and institutions are heavily accumulating stock of those gainers by a ratio of 2 to 1, basically lots of Advancing Volume. The calculation would be as follows:
(2/1)/(2/1) = 1.0
An Arms Index reading of one is supposed to be neutral, yet the example up above was extremely bullish. Suppose Advancing Issues were 3 to 1 and Advancing Volume was 2 to 1. This is yet another bullish scenario. This calculation is shown next:
(3/1)/(2/1) = 1.5
A reading of 1.5 is extremely bearish, yet Advancing Issues outpaced Declining Issues by 3 to 1 and Advancing Volume outpaced Declining Volume by a ratio of 2 to 1; very bullish inputs.
By reversing the previous scenario and making Advancing Issues stronger by a ratio of 2 to 1 and Advancing Volume stronger by a ratio of 3 to 1, the status quo interpretation of the Arms Index is found.
(2/1)/(3/1) = 0.67
The result, 0.67, is a strong bullish reading confirming this calculation's bullish inputs of 2 to 1 Advancing Issues and 3 to 1 Advancing Volume.
What Does This All Mean?
The Arms Index emphasizes volume. In the first example, there was twice as many Advancing Issues and twice as much Advancing Volume. Therefore, 67% (2 to 1 is equal to a 67% and 33% split) of all NYSE issues were advancing, and subsequently 67% of all NYSE volume was with Advancing Issues. For the Arms Index to give a bullish reading, the Arms Index would expect there to be more volume poured into the advancing stocks, such as in the last example where 75% (3 to 1 is 75%) of all NYSE volume was in Advancing Issues.
Nevertheless, a person could legitimately question why 67% of all NYSE issues being gainers and 67% of all volume being with winning issues could be considered neutral.
Arms Index Alternatives
Separating the two components of the Arms Index is a viable alternative.
- (Advancing Issues / Declining Issues) is called the Advance/Decline Ratio
- (Advancing Volume / Declining Volume) is called the Upside/Downside Ratio.
Another alternative to look into is creating an average volume per issue; this is shown below:
- (Advancing Volume / Advancing Issues) / (Declining Volume / Declining Issues)
This version is more intuitive; it would be bullish above one because there would be more average volume per up issue and the indicator would be bearish below one because there would be higher average down volume per issue. The same type of problems could arise as those with the Arms Index. In this case, very few issues could be gainers, but the stocks that were gainers could have high amounts of volume. Thus the top half of the equation would be greater than the bottom half, returning a bullish signal, even though very few stocks advanced that day.
Probably the best alternative to the Arms Index is the market thrust indicator (see: Market Thrust); its formula is as follows:
- (Advancing Issues x Advancing Volume) - (Declining Issues x Declining Volume)
With the market thrust indicator, the more advancing issues, the larger the market thrust value. Similarly, the more advancing volume, the larger the market thrust value.
Of course, by using math and an imagination, a trader could come up with various other combinations.
Moral of the story: It is important to be a knowledgeable trader and know what the strengths and weaknesses of each technical indicator is; also, don't rely on just one indicator.
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