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Ed. Note - These mailbag articles first appeared on StockCharts.com back in 2000. They are just as valuable now as they were then, so we've added them to our new Mailbag blog. Enjoy!
Q: It is my understanding that a TRIN above 1 is bullish and a TRIN below 1 is bearish. Is this correct?
A: There are a number of analysis interpretations that have evolved over the years. Richard Arms, the originator, uses the TRIN to detect extreme conditions in the market. He considers the market to be overbought when the 10-day moving average of the TRIN declines below .8 and oversold when it moves above 1.2. Other interpretations seek to use the direction and absolute level of the TRIN to determine bullish and bearish scenarios. In the momentum markets, the TRIN can remain oversold or overbought for extended periods of time.
TRIN = ((Advancing issues/declining issues) / (advancing volume/declining volume))
Note: On StockCharts.com, '$TRIN' is the NYSE TRIN and '$TRINQ' is the Nasdaq TRIN
A TRIN above 1 indicates that volume in the declining stocks outpaced volume in advancing stocks and is considered bearish. A TRIN below 1 indicates that volume in the declining stocks outpaced volume in advancing stocks. Because of its inverse relationship to the market, the TRIN's scale is sometimes shown inverted. That's how I show it on the Market ChartTour.
I have personally found that using overbought and oversold readings to trade with the TRIN have not worked as well as direction and absolute level, especially in this momentum-driven market. In addition, overbought does not necessarily imply a bearish situation as oversold does not imply a bullish situation. I prefer to treat it as simply bullish or bearish and look for divergences followed by crosses into bullish (below 1) and bearish territory (above 1).
- Arthur Hill
Q: What is the method behind the madness of Chaikin Money Flow? Is it deficient because it ignores gaps?
A: Chaikin Money Flow is based on the formula for the Accumulation/Distribution Line.
One Period = (((C-L)-(H-C))/(H-L)) x Volume
To form the Accumulation/Distribution Line, each period's value is added (or subtracted as the case may be) to the next period to form a cumulative line. The formula is made up of two parts: the volume multiplier and the volume. The volume multiplier calculates the location of the close relative to the high and low for the period. The volume multiplier is positive when the close is above the mid-point of the high/low range and negative when the close is below the mid-point. The highest reading comes when the close equals the high (+1) and the lowest reading comes when the close equals the low (-1). Chaikin Money Flow is the 21-day moving average of the above formula, divided by the 21-day moving average of volume.
The formula can be tricky when used for illiquid securities or when large gaps occur. If the H = L then the reading would be zero, which it deserves because there was no evidence of buying or selling pressure. Not accounting for gaps (or change from close to close) is one of the weaknesses of Chaikin Money Flow. A stock can gap down 20%, but close on the high and have a positive Chaikin Money Flow (SBUX Jul-99). Chaikin was more interested in capturing intraday price action, especially the location of the close. The volume on opening trades is rarely more than 10% of the daily total, even on large gaps. If you are concerned about this, you may want to look at On Balance Volume, which measures only the close.
- Arthur Hill
Q: What is the most important aspect of stock selection?
A: I believe that sector is the most important aspect of stock selection. There is a lot of rotation in the stock market and being in the right sector is often more important than being in the right stock. I would rank stock selection priorities as follows:
- Sector/group
- Broader market
- Individual Stocks
Some groups are more highly correlated than others. Recently, the biotech advance and correction provides an excellent example of a highly correlated group. Other groups that are highly correlated include: airlines, banks, chemicals, gold, internet (B2B, Portals, etailers, brokers), oil service, paper, pharmaceuticals and semi-conductors. Some groups with less correlation may include computer hardware, software, data storage, gaming and insurance. Even if the correlation is not that high, a stock's group or sector exerts much influence and should not be ignored.
- Arthur Hill
Q: Once a stock is selected, what is important for a generating a buy or sell signal?
A: It is tough to set this in stone and no two setups are exactly alike. However, I would rank the order of importance as follows:
- Price action - support, resistance, chart pattern, candlesticks and volume.
- Indicators - momentum
- Reward-to-risk ratio
- Indicators - money flows
I am certain that the price action should be first and foremost. The other three are a distant second and I believe that momentum ranks just above the other two. I like to make sure that momentum is moving in the same direction as my trade before initiating a position. Reward-torisk ratio is very important to trading, but can sometimes conflict with technical analysis. Money flow, while important, can lag a bit.
Just as important to buy and sell considerations are each individual's trading style, goals and risk tolerance. There are many trading and investing styles, but I think of them as three basic categories: early birds, turn confirmers and trend followers.
Early birds pick bottoms and tops before there is evidence of a reversal. Support, resistance and target levels are looked upon as buying or selling opportunities. Those who concentrate on tight money management might buy at support and sell at resistance. There may be little evidence of a reversal, but support levels usually offer a good reward-to-risk ratio with a tight stop-loss just below support. Tom DeMark uses exhaustion techniques to pick bottoms and tops for buying and selling. Some may see it as a free fall or parabolic advance, but DeMark looks for signs of exhaustion to trade the reversal. This is a very gutsy approach, but DeMark has great credentials.
Turn confirmers look for evidence of a base, a reversal and then some sort of breakout to confirm. I would place myself in this category. I am usually not going to pick the exact bottom or top and will be whipsawed sometimes. However, I feel more comfortable waiting for the confirmation. In addition, my reward-to-risk ratio sometimes suffers by waiting for confirmation.
Trend followers are usually the late comers and wait for solid evidence of a change in trend before initiating a position. The pitfalls of this approach are late entry and exit, poor reward-to-risk ratios and large whipsaws.
These three different styles highlight the ongoing battle in technical analysis and trading. Traders want the best reward-to-risk ratio, but technical analysts want to see evidence of a reversal before turning bullish. The early birds are at one extreme and the trend followers at the other. The earlier you buy, the closer the stop-loss and the better the reward-to-risk ratio. However, early entry usually means there is less evidence of a reversal. It is a tough call and traders need to find the approach that best suits their particular style. I am trying to position myself in the middle by balancing reversal confirmation with a good reward-to-risk ratio.
- Arthur Hill
