In this article I’m going to present another timing method that is 70% correct and consistently pulls money from both the S&P 500 market and the Mini DOW since 1997. The overall philosophy of the strategy will be to buy pullbacks within an uptrend and exit when price reaches a short term over bought level. The basis for the strategy can be found in a book called “Short Term Trading Strategies That Work” by Larry Connors and Cesar Alvarez. Throughout the article I’m going to modify their basic strategy to take advantage of other trading techniques.
Many trading systems and indicators generate their buy/sell signals from price. What this means is a lot of people are looking at price. When it comes to making money in the financial markets, if a lot of people are doing something, it can often be to your benefit to look elsewhere for answers! Thus, non-price based information can lead to powerful edges you can exploit. A common non-price based indicator is volume. Many traders will use volume or an indicator that uses volume to help make buy/sell decisions. Another is the put/call ratio which measures the number of open puts vs. the number of open calls. In this article I’m going to look at the ARMS index.
The ARMS index is more commonly known as the TRIN (Short-Term TRading INdex). The TRIN measures the bearishness or bullishness of a group of stocks. In this case all stocks on the NYSE. The calculation looks like this:
TRIN = ( Advance Decline Ratio / Advance Decline Volume Ratio )
Advance Decline Ratio = Advancing stocks / Declining Stocks
Advance Decline Volume Ratio = Total Volume of Advancing Stocks / Total Volume of Declining Stocks )
Generally speaking, a TRIN value below the value of one demonstrates relative strength in the advance/decline ratio which is a more bullish market. On the other hand, a TRIN value above the value one shows relative weakness in the advance/decline ratio which is more bearish in nature.
The TRIN is below 1 when the AD Volume Ratio is greater than the AD Ratio and above 1 when the AD Volume Ratio is less than the AD Ratio. Low readings, below 1, indicate strength in the AD Volume Ratio. High readings, above 1, indicate relative weakness in the AD Volume Ratio. In general, strong market advances are accompanied by relatively low TRIN readings. As you can see the TRIN value is inverse to the price of a rising index such as the NYSE.
Let’s get down to business to creating our strategy. We’ll use a trend filter to define the overall market mode (bullish or bearish). We’ll do this by using a 200-day simple moving average (SMA). When price is above its 200-day moving average the market is in bullish mode. In our example strategy we will be going long only.
For timing our entry we are going to use two indicators. Our first indicator is our battle tested 2-period RSI which must be below 50, which indicates some short-term price weakness. Our next indicator is the NYSE TRIN index. This indicator must close above 1.00 for three consecutive days. An elevated TRIN index shows sustained bearish pressure on price. Coupling these two bearish indicators together produces our buy signal. When we buy into weakness in an overall bullish market and exiting our position upon short-term market strength we are capitalizing on an over stock index edge that has been holding strong for over a decade. Furthermore, what’s nice about this particular setup is we have two indicators confirming our entry point. One is price based (RSI) and the other is non-price based (TRIN). So, we are getting confirmation from two independent sources. We open our position at the open of the next day. Our exit is even more simple than our entry rules. Once a position is opened we simply exit the trade at the close of the day if the daily 2-period RSI reads above 65.
I coded these rules in EasyLanguage and tested it on the S&P E-Mini futures market. A total of $30 per round trip was deducted for commissions and slippage. Below is a screen shot of some example trades. Below the ES market you will see the TRIN index and the RSI(2) indicator.
Not too bad for a proof of concept. Remember, this strategy has no stops and we can see this really hurt us in late summer of 2011 when the market nosed dived. However, given such simple rules with no stop loss it seems we might have a decent trading idea.
The Long-Only system only takes trades during a bull market. During a bear market we simply sit on the sidelines in cash. But bear markets present opportunities as well. Let’s add another buying rule to open new positions during a bear market. Based upon past market studies we’ve performed on the System Trader Success website, we can make an assumption in regards to how price behaves during a bear market. Most notably, the market can experience much deeper and stronger sell-offs. Thus, when we are looking for an entry signal, we will want to see our RSI value be much lower than the value used during a bull market. During a bull market we are simply looking for the RSI value to be below 50. In a bear market we will want the RSI value to be below 10.
Our new bear market entry rules look like this:
The trading concept presented in this article is a great example of using both a price based indicator along with a non-price based indicator as an entry signal. Please remember, as it stands now, this is not a complete trading system. For example, there are no stops or money management rules. However, it’s a great starting point from which you can build your own trading system.
Jeff is the founder of System Trader Success - a website and mission to empowering the retail trader with the proper knowledge and tools to become a profitable trader the world of quantitative/automated trading.