To print article, click Print on your browser's File menu. Go back Posted 5/24/2001 Related Resources Keep track of Victor Niederhoffer and Laurel Kenner's picks on their Recommendations page. Also follow their HighVolatility portfolio. Read their article on the Volatility Index, "Make volatility and uncertainty your friend." We can't prove TRIN doesn't work, any more than we can prove that there are no black swans.	sponsored by: The Speculator An investing tool you can do without The Arms Index pinpointed the market bottom on March 22, but does it have any practical use as an investing tool? If it does, we couldn't find it. By Victor Niederhoffer and Laurel Kenner Oh, how do you solve a problem like Maria? How do you hold a moonbeam in your hand? -- Oscar Hammerstein, lyrics for "Maria," from "The Sound of Music" Money Plus. Easy online tools and free Bill Pay, too. The NYSE Short Term Trade Index ($TRIN), or the "Arms Index," flashes past the eyes of CNBC viewers every 20 minutes and is one of the most widely used indicators in market technicians' toolkits. An examination of it seems like a nice supplement to our recent workouts on the value of the stock-bond ratio and Volatility Index ($VIX.X). The Arms Index represents the ratio of New York Stock Exchange up volume scaled down by number of rises, divided by the ratio of down volume, scaled down by the number of declines. The index has had some favorable press recently. Don Hays, in an interview with Barron's, used it to call the exact recent bottom of the Dow ($INDU) on March 22. Richard Arms, the inventor of the index, did likewise in his $8,000-a-year advisory for institutional clients. Some traders use a five-day average for short-term forecasts. So TRIN works, right? Not so fast. TRIN may have worked on March 22. But that doesn't begin to make up for all the times it didn't work. We studied the index from dozens of vantage points. We looked at the correlation of one-day, two-day, five-day and 10-day TRIN with S&P 500 Index ($INX) moves over the next one, five and 10 days. Briefly, we found the results to be completely consistent with randomness, with correlations close to or right at zero over the last three and a half years. In other words, TRIN doesn't predict the future. We're not the only ones to find difficulties with TRIN. In "The Encyclopedia of Technical Market Indicators," Robert Colby and Thomas Meyers tested the TRIN from January 1928 to March 1987. They performed many different tests using daily data to come up with predictions over the next one to 12 months. Their findings: "We can only conclude that it has relatively limited forecasting value for stock prices." Some may feel that conclusion is premature, as it is built on only 59 years of data. But in "The New Technical Trader," Tushar Chande and Stanley Kroll noted three difficulties with using TRIN. The ratios used in TRIN often obscure market action. This is particularly true when we have "mixed" market action. The very process of smoothing TRIN with moving averages distorts the picture of relative volume flows. The TRIN has a bounded scale for upside activity, but an unbounded scale for downside activity. We talked to Richard Arms about how he uses TRIN (by the way, he prefers to call it the Arms Index), and about our findings. In his words: Laurel: Do you trade much? Arms: I trade some money for myself, but my primary work is talking with my clients. I put out an advisory for dozens of institutions. I don't trade much any more, because I'm occupied with other things. Laurel: Millionaire? Centimillionaire? Arms: Somewhere in the middle. Laurel: From trading? Arms: From trading, and from the fees I charge my clients. Laurel: How would you advise people to use the index? Arms: If you're a trader, watch the five-day moving average. When it's in the 0.75 sort of area you become a seller and when it's over 1.25 you become a buyer. It's a judgment thing....The 10-day moving average allowed us to call the bottom perfectly on March 22. Laurel: Can you elaborate on how to use judgment? Arms: After working with it for so many years it becomes a little … instinctive. I'm not sure I can explain it really. I explain it to my...institutional clients. I look at a lot of things. I'm not just looking blindly at this index and saying buy or sell. It's not just a simplistic sort of thing. Laurel: How many times have you used the Arms index as a primary signal in the past five years? Arms: It's given only two of those big major signals in the last five years. This one and in October 1997. Then we have to go back to 1987 to get a similar signal. If there's proof, we can't find it The problem is, the "buy" levels for the 10-day average don't happen enough to scientifically evaluate TRIN. You can't estimate uncertainty based on something that happens twice every five years. Also, the signals happen to occur at times when the market is most down, so basically what you're taking advantage of is the old adage to buy in panics. As for the five-day indicator, not even Arms relies on it alone. We told Arms that we had found no correlation between TRIN's moving averages and subsequent S&P 500 moves, and he said it bothered him to hear us say that. "All of Wall Street uses the index," he said, "because it works." We can't prove TRIN doesn't work, any more than we can prove that there are no black swans. It's like a will o' the wisp, or, as the song goes, like holding a moonbeam in your hands. Statistically, it's very difficult to evaluate a ratio of two ratios. In technical terms, the distribution of the ratio of two normal variables has an infinite mean and an infinite variance. In other words, larger samples don't help you reduce your uncertainty about the mean or variability of the indicator. Arithmetically, the ratio is also intractable. Its variations are dominated by changes in volume. The volume moves are highly correlated with price changes. The ratio itself varies from 0 to infinity. A much more well-behaved measure would be based on the differences between the volumes and advances vs. declines, perhaps with a logarithmic operator thrown in for stability.
Recent Articles • How the Fed's moves shake markets, 5/17/01 • Last year's casualties are this year's prospects, 5/10/01 • Make volatility and uncertainty your friend, 5/3/01 more...	Whatever we say about TRIN, we have no doubt that someone will write in to say we are misinterpreting it, and that we should have looked at it this or the other way. We wish users of this ratio of ratios good fortune, and hope there are experts out there who have nonlinear ways of using it or selected levels at which they have confidence it will magically give a significant augury. David Simon and Roy Wiggins, the Bentley professors we cited in our volatility article, did in fact conclude that TRIN has a small incremental value as a daily forecasting tool, when combined with VIX and the put-call ratio. But as for us, the indicator brings to mind the story of the Hydra, the nine-headed monster allowed to live by Zeus as a challenge to heroes. The fumes from any of its heads were enough to kill any hero. And when one head was destroyed, two grew in its place. Agree? Disagree? In preparing this article, we, together with Dr. Brett Steenbarger, ran hundreds of regressions with many lags and leads for many different back periods. We welcome reader comment, and will be happy to share our results, some of which are quite technical, with interested readers. Mail us here. MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.