From the May 01, 2007 issue of Futures Magazine • Subscribe!

A new trick for an old indicator

The Trin is one of the most widely followed market timing indicators is the Trin. It can be found reported on and discussed in publications such as The Wall Street Journal, Barron’s, Investor’s Business Daily, and on the Web and charting platforms. However, despite this popularity and longevity — the Trin has been widely available for more than 30 years — there are not many statistical studies that objectively determine that the indicator actually works.

As such, there are few sources that teach how to apply it effectively to your trading.

Recent research does, in fact, show that the Trin can be used to time the market — if it is used the right way. This article will describe a new quantified strategy derived from this research and the TradingMarkets Market Timing Course. This strategy, which has at its heart the traditional Trin indicator, can potentially provide traders with a statistically backed predictive edge for timing the market on a short-term basis.

Moreover, this edge can be used to trade S&P 500 E-Minis, S&P Depository Receipts (SPDRs), options or any other instrument that is both liquid and tied to the overall direction of the broad stock market. Before we get to the rules of this new strategy, though, it’s important to understand exactly what the Trin is and what is was originally designed to accomplish.

WHAT IS THE TRIN?

The Trin was created in 1968 by Richard Arms. It is also known as the Arms Index. The premise of the Trin is that in a rising market, there is more volume in advancing issues than in declining issues, and that the opposite is the case for a declining market. It’s actually quite a simple calculation. The Trin indicator calculates and tracks this relationship using the formula shown below in red.

To better understand on a practical level what the Trin tells you, assume that the reading, that is, the result of the formula, is 1.0. Most followers of the Trin take this to mean that the market is in a state of equilibrium.

If the Trin is above 1.0, it indicates that there is more volume in declining stocks, while a Trin reading below 1.0 indicates there is more volume in advancing stocks.

The most popular interpretation of the Trin indicator is to use it to time the market as follows:

• A reading below 1.0 is bullish

• A reading above 1.0 is bearish

Further research, however, has taken these observations a step further and has refined them to provide a statistically significant edge in identifying short-term moves in the markets. The results suggest several new ways to use the Trin to time the market. One of them has shown to be considerably reliable for capturing short-term market moves.

FOUR RULES FOR THE TRIN

Here is a straightforward, quantified method to use the Trin in a new way. It can be applied to trade E-Minis, SPDRs or index options. These four simple rules were applied to the E-Minis since contract inception in September 1997:

1. If the S&P 500 E-Mini continuous contract is above the 200-day simple moving average and

2. The Trin closes above 1.0 for three consecutive days, then

3. On the day this happens, buy the market on the close and

4. Exit when the S&P 500 E-Mini closes above the five-day simple moving average.

Using the 200-day simple moving average as a filter — in other words, only taking long trades when the market is in a general uptrend — this strategy waits for the Trin to close above 1.0 three days in row. Following these rules to the letter, this condition has occurred 74 times since the launch of the E-Minis in September 1997. The market closed higher 72% of the time.

The average hold for these signals has been less than five days. We can use this average hold time to put the results of the strategy in perspective. For example, looking at every trading day for the E-Minis, the market has closed higher five days later 57% of the time when prices have been above the 200-day moving average. By waiting for the Trin to close three days in a row above 1.0, in addition to the moving average filter, the edge increases to 72%. In trading terms, this is a huge improvement.

Even though there is no guarantee these results will hold in the future, they do add credence to the Trin as an indicator that traders can build quantified strategies around.

WHY IT WORKS

These results strongly suggest that the ratio of advancing stock volume to declining stock volume is mean-reverting. That means that over the course of time, a normal range is established and if the ratio veers too far from that average, it is destined to snap back to normality.

Three consecutive days of Trin levels above 1.0 is a relatively rare condition in which declining volume is sustained at high level for an extended period. Historically, this condition has tended to quickly unwind itself back to the norm, resulting in a rising market through the next few days.

One drawback to this strategy is that it has generated only 74 signals and has been in the market about 300 days since 1997.

It doesn’t trade much; however, if you use this strategy along with others to help guide your decisions on a day-to-day basis, you have the beginnings of a solid market timing methodology.

Two recent examples that show how this indicator typically forecasts forthcoming, short-term rises in the stock market are shown in “Tied to the Trin”.

This simple, yet quantified strategy for using the Trin can be used to guide trading decisions in index-related vehicles, such as the E-minis, SPYs and broad-based options.

This strategy is only one of many different model-driven approaches that can be discovered through careful research on short-term market behavior.

Larry Connors is CEO and founder of TradingMarkets.com and Connors Research. Ashton Dorkins is editor-in-chief of TradingMarkets.com and can be reached at editor@tradingmarkets.com.

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