means peri-ods of high volatility are likely to revert back to their normal levels andperiods of low volatility also revert back to their normal levels. 1 havefound that this concept is an inherent feature of the VIX. Dave and Ifound that by applying the reversion to the mean principle, we could pre-dict S&P behavior. We found that whenever the VIX closed 10 percentabove or below its 10-day moving average, it had a tendency to revertback to its mean. At the same time stock market prices also reversed.
Here are the rules of the “Connors VIX Reversal III” (CVR HD):
FOR BUYS
1. Today, the low of the VIX must be above its 10-day moving average.
2. Today, the VIX must close at least 10 percent above its 10-day mov-ing average.
3. If rules 1 and 2 are met, buy the market on the close.Exit (on the close) the day the VIX trades (intraday) below yester-day’s 10-day moving average (reversion to the mean).
FOR SELLS
1. Today, the high of the VIX must be below its 10-day moving average.
2. Today, the VIX must close at least 10 percent below its 10-day mov-ing average.3. If rules 1 and 2 are met, sell on the close.
4. — Exit (on the close) the day the VIX trades (intraday) above yester-day’s 10-day moving average (reversion to the mean).
 Connors VIX Reversals
 
 
 
CVR Ili S&P 500 Index—CME—Daily—01/01/93-10/01/97
Performance Summary: All TradesTotal net profit $ 120,675.00 Open position P/LGross profit $ 176,250.00 Gross lossTotal number of trades 6 Percent profitableNumber winning trades ca Number losing tradesLargest winning trade $ 14,425.00 Largest losing tradeAverage winning trade $ 3,263.89 Average losing tradeRatio average win/average loss 123 Average trade (win and loss)Maximum consecutive winners w Maximum consecutive losersAverage number bars in winners 4 Average number bars in losersMaximum intraday drawdown $ -22925.00Profit factor 3.17 Maximum number contracts heldAccount size required $ 22,025.00 Return on account
Performance Summary: Long Trades‘Total net profit $ 7450.00 Open position P/LGross profit $ 88,625.00 Gross loosTotal nuinber of trades a Percent profitableNumber winning trades 32 Number losing tradesLargest winning trade $ 1425.00 Largest losing tradeAverage winning trade $ 2,769.53 Average losing tradeRatio average win/average loss. 1.76 Average trade (win and toss)Maximum consecutive winners 9 Maximum consecutive losersAverage number bars in winners 4 Average number bars in losersMaximum intraday drawdown, $ -19,050.00Profit factor 6.25 Maximum number contracts heldAccount size required $ 19,050.00 Return on accountPerformance Summary: Short Trades
Total net profit $ 4622500 Open position P/L‘Gross profit $ 87,625.00 Gross lossTota! nemter of trades 4 Percent profitableNumber winning trades 2 Number losing tradesLargest winning trade $ 14,400.00 Largest losing tradeAverage winning trade $ 3,982.95 Average losing tradeRatio average win/average loss 1.15 Average trade (win and loss)Maximum consecutive winners 5 Maxdnium consecutive losersAverage number bars in winners 4 Average number bars in josersMaximum intraday drawdown $ -20,92500Profit factor 212 Maximum number contracts held
Account size required
$ 20,825.00 Return on account
ow
wae
wn
we
wae
9.0055,575.00
2
~10,025.002,646.431,609.00
548%
0.0014,175.90
-2,950.001,575.001815.85
WI%
0.0041,400.00
12
10,025.003,450.001,399.56
2%
 
15
 SS16 Chapter 2
SUMMARY
As you can see, the results are solid both to the long and short side. Theaverage profit per trade is excellent and the percent profitable is alsoquite strong. Finally, as always, a protective stop helps avoid potentiallylarge drawdowns.
In my opinion, and as you can see from the three CVR strategies, the VIXis a superior vehicle to the put/call ratio for using options to predictmarket direction, By combining the three reversal methods, you will beable to identify reversals in the stock market on a more efficient basis. 
CHAPTER 3
TRIN THRUSTS
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This chapter focuses on another method to time the overall market. The“TRIN Thrust Strategy” is one that will be of special interest to S&P fu-tures traders, mutual fund timers, and OEX traders.
As you probably know, the TRIN is the NYSE Short-Term Trading Index.It was originally called the ARMS Index in honor of its creator DickArms.
The TRIN measures a ratio of the number of advances and declines on.the NYSE and relates those totals to the up-and-down volume activity inthe stocks. Wall Street views extended periods above 1.00 as an indicationof a weak market and extended periods below 1.00 as an indication of astrong market. The TRIN Thrust strategy does not look at the readingsthis way. It simply looks at the daily percentage change in the closingTRIN from yesterday tc today to predict the market direction for the nexttwo trading days.
As was just mentioned, the TRIN is used to identify strong and weakmarkets. Conventional wisdom (this term should now make you nerv-ous) states that extended readings above 1.00 indicate the market is over-sold and due to decline; extended readings below 1.00 signal the marketis overbought and due to rise.
 
17 
18
Chapter 3
This arbitrary generalization in the selection of greater than 1.00 or lessthan 1.00 for the TRIN carries as little weight of evidence as someonetelling us a VIX reading above a certain number means the market isoversold or an advance/decline reading above a certain number meansthe market is overbought. Such generalities are what cause traders to gethurt badly when overbought becomes more overbought and oversold be-comes even more oversold.
Does this failure of absolute TRIN values to predict market turns meanit’s a useless indicator? No, only that in my opinion and experience, ithas been and is misused by the majority on Wall Street.
Instead of looking at the TRIN as an oscillator which varies betweenoverbought and oversold, let’s break it down to its core components, aswe did with the VIX, and then see how it adds to our understanding ofcurrent market action.
« By measuring the flow of funds into and out of stocks relative to theirvolume, the TRIN does signal that a market has been strong or weak.
« We also know that many times the market moves to an area that isoverbought and remains that way until some force causes it to revertto the mean and pulls it back into oversold territory.
+ Aswesaw with the VIX, for this change in direction to take place, themarket's momentum needs to be stopped and reversed.
‘Taking these pieces into consideration, I have found that sharp one-dayreversals (thrusts) off the TRIN are often the beginning of a one- to two-day general market reversal. (That is, the sharp change in the percentageTRIN reading is indicative of a momentum change and this new momen-tum surge takes approximately two days to run its course.)
Before looking at the mules, you must know that I rarely use the TRINThrust signal as a stand-alone indicator. It is much more effective when it iscombined with another signal such as a VIX reversal or a short-term pattern.This combination, many times, gives further confirmation to the pendingmove.TRIN Thrusts 19
FOR BUYS
1. If today’s closing TRIN is 30 percent or more below yesterday's clos-ing TRIN, buy the market on the close today. For example, yester-day’s closing TRIN reading was 1.00. If today’s closing TRINreading is .70 or less, buy the market.
2. — Sell on the close two trading days later.
3. For your protection, I strongly recommend using a 1 1/2 to 2 per-cent protective stop. This means if the S&P’s are at 900, your stopshould be in the 982 to 987 range.
FOR SELLS
1, If today’s closing TRIN is 30 percent or more above yesterday'sclosing TRIN, sell the market on the close today. For example, yes-terday’s closing TRIN reading was .70. If today’s closing TRIN is .91or higher, sell the market.
2. Close the position two trading days later.
3. Use a 1 1/2 to 2 percent protective stop.
Here are the mechanical results using a 1 1/2 percent stop.AS
20
 
Chapter 3TRIN Thrust S&P 500 Index—CME—Daily 01/03/90-10/01/97
Performance Summary: All Trades
Total net profit $ 186,495.00 Open position P/L
Gross profit $ 851,195.00 Gross loss
Total number of trades 764 Percent profitable
Number winning trades 387 Number losing trades
Largest winning trade $ 14,665.00 Largest losing trade
Average winning trade $ 2,199.47 Average losing trade
Ratio average win/average loss 1.25 Average trade (win and loss)
Maximum consecutive winners 9 Maximum consecutive losers
Average number bars in winners 2 Average number bars in losers
Maximum intraday drawdown $ -37,350.00
Profit factor 1.28 Maximum number contracts held
Account size required $ 37,350.00 Return on account
Performance Summary: Long Trades
Total net profit $ 19753500 Open position P/L
Gross profit $ 439,955.00 Gross loss
Total number of trades 342 Percent profitable
Number winning trades 194 Number losing trades
Largest winning trade $ 13,800.00 Largest losing trade
Average winning trade $ 2,263.17 Average losing trade
Ratio average win/average loss 1.39 Average trade (win and loss)
Maximum consecutive winners 9 ‘Maximum consecutive losers
Average number bars in winners 2 Average number bars in losers
Maximum intraday drawdown $. -29,175.00,
Profit factor 1.82 Maximum number contracts held
Account size required $ 29,175.00 Return on account
Performance Summary: Short Trades
Total net profit $ -11040.00 Open position P/L
Gross profit $ 412,140.00 Gross loss
‘Tota! number of trades 42 Percent profitable
Number winning trades 193 Number losing trades
Largest winning trade $  14665.00 Largest losing trade
Average winning trade $ 2,135.44 Average losing trade
Ratio average win/average loss 1.16 Average trade (win and loss)
Maximum consecutive winners 6 Maximum consecutive losers
Average number bars in winners 2 Average number bars in losers
Maximum intraday drawdown $ -55,800.00
Profit factor 0.97 Maximum number contracts held
Account size required $ 55,800.00 Return on account
 
$ -4,450.00$ -664,700.0051%
377$ -12,875.00$ 1,763.13$ 244.10
Nn
1
1499%$ 0.00$ -241,520.0057%
148$ 12,875.00$ ~1,63189$ 57759
12
1
1677%$ ~423,180.0046%
29$ -12,250.00$  -1,847.95$ 26,16
 
 
 TRIN Thrusts
SUMMARY
As with the Connors VIX Reversal, the TRIN Thrust strategy shows goodprofits. Even though the per-trade profit is lower than the VIX strategies,it does provide us with a small edge. Also, as I mentioned, this strategyshould not be used as a stand-alone indicator. Use it in conjunction withother signals. In addition, as you can see, the strategy did significantlybetter on the long side than on the short side. This is due to the seven-year run the market has had. In 1990 and 1994, the two weakest years ofthe period, TRIN Thrusts showed good profits on the short side. When abear market occurs, the results on the long side will be less and the re-sults on the short side should increase substantially.
With the new smaller S&P futures contract, and derivative products forthe Dow Jones Index, the TRIN Thrust strategy, combined with other in-dicators, should be helpful in assisting you to successfully trade thesenew vehicles.
21 
CHAPTER 4
PERCENT ADVANCE/DECLINE INDICATOR(PADI)
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The “Percent Advance/Decline Indicator” (PADD, is one of the betteradvance/decline indicators I have developed. As you will see from theresults, it does a good job of identifying short-term tops and bottoms inthe stock market and in the S&P futures.
In my opinion, advance/decline indicators do a very good job of identi-fying overbought and oversold stock market conditions. Unfortunately,the overwhelming number of traders use them as a static indicator andinstead of increasing profits, lose money trading with them. Why is this?Because, as I’ve written again and again, markets that are overbought canand will become more overbought, and markets that are oversold canand will become more oversold. The fact that an advance/deciine indica-tor has reached some extreme number absolutely does not mean that themarket cannot move to even more extreme levels. I have seen too manytraders use these fixed static numbers as if they were the Holy Grail andeventually get killed as the market kept running against them. 
24
Chapter 4
To take full advantage of these indicators, the market itself must first sig-nal a reversal. This means that even when the market is grossly oversold,until the indicator reverses, you must remain patient. By letting the mar-ket reverse, you are not putting yourself in front of a speeding train in anattempt to stop it. Therefore, we must use a method that shows the mar-ket is either overbought or oversold and then combine it with a method-ology that signals a clear reversal. Also, I have found it to be even moreadvantageous to only trade advance/decline setups in the direction ofthe market’s longer-term trend.
Here are the calculations and rules for the PADI:
1. Add the total number of shares traded today on the NYSE. This isdone by adding the advances, declines, and unchanged.
2. Divide the number of advancing issues by the total issues traded(advances + total) to get today’s advancing percent.
3. Divide the number of declining issues by the total issues traded(declines + total) to get today’s declining percent.
4. Take the six-day average of the advancing percent and the six-dayaverage of the declining percentage.
5. If yesterday's advancing average was 40 percent or higher and to-day’s advancing average is less than yesterday’s advancing average,sell on the close (only if the stock market is trading below its 100-day moving average).
6. If yesterday's declining average was 40 percent or higher and to-day’s declining average is less than yesterday's declining average,we buy on the close (only if the market is trading above its 100-daymoving average).
7. Exit in five to seven days or if there is a signal in the oppositedirection.
As with the other strategies, I recommend using a protective stop. Hereare the results using a 1 1/2 percent stop with a five-day exit.Percent Advance/Decline Indicator (PADI) 25
 
PADI S&P 500 Index—CME—Daily 01/01/90-10/03/97
Performance Summary: All Trades
 
Total net profit $ 14293250 Open position P/L $ 0.00Gross profit $ 285,525.00 Gross loss $ -142,592.50Total number of trades 109 Percent profitable 61%Number winning trades 66 © Number losing trades 43Largest winning trade $ 18,775.00 Largest losing trade $  -7,725.00Average winning trade $ 4326.14 Average losing trade $ -3316.10Ratio average win/average loss 1.30 Average trade (win and loss) $ 13031Maximum consecutive winners 7 Maximum consecutive losers 4Average number bars in winners 6 Average number bars in losers 5Maximum intraday drawdown $ -17,340.00Profit factor 2.00 Maximum number contracts held 1Account size required $ 17,340.00 Retum on account 824%Performance Summary: Long Trades *Total net profit $ 12591250 Open position P/L $ 0.00Gross profit $ 238,300.00 Gross ioss $ ~112,387.50Total number of trades 83 Percent profitable 4%Number winning trades 53 Number losing trades 30Largest winning trade $ 18,775.00 Largest losing trade $  -7,725.00Average winning trade $ 4496.23 Average losing trade $  -3,74625Ratio average win/average loss 1.20 Average trade (win and loss) $ 151702Maximum consecutive winners 8 Maximum consecutive losers 3Average number bars in winners 6 Average number bars in losers 4Maximum intraday drawdown $ ~17,340.00Profit factor 212 Maximum number contracts held 1Account size required $ 17,340.00 Return on account 726%_ Performance Summary: Short TradesTotal net profit $ 1720.00 Open position P/L. $ 0.00Gross profit $ 47,225.00 Gross loss $ -30,205.00Total number of trades 26 Percent profitable 50%Number winning trades 13 Number losing trades 13Largest winning trade $ 6525.0 Largest losing trade $  ~6,06750Average winning trade $ 363269 Average losing trade $ 2323.46Ratio average win/average loss 156 Average trade (win and loss) $ 654.62Maximum consecutive winners 3 Maximum consecutive losers 3Average number bars in winners 5 Average number bars in losers 6Maximum intraday drawdown $ -9835.00Profit factor 1.56 Maximum number contracts held 1
Account size required $9838.00 Return on account 173%
 a
26
Chapter 4
SUMMARY
The reason I like the PADI is because it is continuously self-adjusting tothe number of issues that are traded each day. This means that whenthere is an onslaught on new issues that flood the market, or when anabundance of takeovers occurs, the PADI will adjust itself to this newnumber. Another point should be made: If you lower the percentage, youwill get more trades and, even though the profit per trade is lower, theresults are favorable.
As I stated earlier, advances versus declines do a good job of identifyingwhen markets become overbought and oversold. By waiting for the mar-ket to reverse, as we have done with our other timing indicators, weimprove their performance significantly.
As we discussed earlier, we want to trade strategies that give us an edge.The five market timing strategies presented give a directional bias which,if traded correctly, leads to that edge. 
SECTION TWO
VOLATILITY
Volatility and its application to trading has been a favorite field of re-search for me. The subject is in its infancy stage and is fertile ground fortraders looking to go beyond the many worn out concepts and strategiesthat exist today.
In the following few chapters I build upon the work I released in Invest-ment Secrets of a Hedge Fund Manager and Street Smarts. For those cf youwho have not read these books, I will attempt to explain some of theideas presented in those publications to heip you further your under-standing of the subject.
A friendly warning: The Volatility section is built upon years of research and isby far the most complex in the book. If it is difficult to grasp at first, don'tdespair. With repeated study it will come and the rewards will be worth the timespent.
27 
CHAPTER 5
MODIFYING TRADE SIZEAND STOP PLACEMENTBASED ON VOLATILITYMEASUREMENT
When I was a junior in high school, I had a chemistry teacher by thename of Lenny Brown (I’ve changed his name to avoid any embarrass-ment to him). Some people felt Lenny had a screw loose (no argumenthere), but most also felt he was a great teacher. One of his quirks, though,was to announce our weekly test scores to the entire class as he passedthem back to us. Whenever someone got zero answers correct (a commonoccurrence), Lenny would look at the paper, announce the student’sname, put a stupid grin on his face, and then in a loud booming voice hewould scream “GOosE EGG” for the grade.”
. 1 was once on the receiving end of Lenny’s wrath. In 1975 1 was a food vendor for the BostonRed Sox. When ihe now famous sixth game of the World Series ended at nearly 1 AM, it leftTittle time to prepare for Lenny’s test of the upcoming moming. To this day, | can still hearLenny screaming “GOOSE EGG” after my name 
30
Chapter 5
In the money management industry it is quite difficult to blow out andget a Lenny Brown goose egg. In 1997, Victor Niederhoffer did. Before Igo on, I need to say that I have absolute respect for Niederhoffer’s ac-complishments, especially up through 1996. He put together one of thebest performance track records of any CTA for over a decade. It was donewith guts, brains, and great trading. This accomplishment can never betaken away from him.
How could a man with his smarts and ability completely blow out? It isimpossible to know the full story, but it appears it was a direct result ofnot adjusting his position size and stops to greatly increased volatility dur-ing the late October 1997 stock market sell-off. This one mistake cost hisinvestors 100 percent of their money and destroyed a terrific career. (Isuspect though, if you are reading this book five years after it was pub-lished, Niederhoifer is probably at the top of the trading world again.)
Let’s look at what adjusting your stop and position size to current volatil-ity actually means. Every stock and commodity has its own volatilityreading. For example, two stocks trade at $100 per share. If stock A has ahistorical volatility reading of 10 percent, this means its annualized trad-ing range was between 90 and 110, two-thirds of the time (based on anassumptive normal distribution). If we assume that the volatility will re-main at 10 percent, we can safely assume the stock will trade between 90and 110 two-thirds of the time over the next year, and we can get a feel ofwhat our risk will be and where we can safely place stops.
Stock B has a 100-day volatility reading of 25 percent. This means that itsannualized range has been between 75 and 125 two-thirds of the time(based on an assumptive normal distribution). Looking back, stock B ismore volatile than stock A.
Going forward, if the volatility of these stocks stays the same, our draw-downs (assuming we don’t use stops) from stock B will be higher thanstock A and our profits when we are correct are likely to be higher thanwith stock A. Therefore, if you go into a trade telling yourself you willtisk 2 points, you are much more likely to be stopped out of stock B thanstock A. Also, if you trade with 100 percent of your cash, you will bemuch more likely to be destroyed by stock B than stock A.
Now let's look at what happens when volatility drastically changes (ashappened to Niederhoffer in October). Stock A, with the 10 percent vola-tility all of a sudden sees its volatility explode to 40 percent. This meansthere is a 67 percent chance that stock A’s price will be within 60 and 140
  
Modifying Trade Size and Stop Placement Based on Volatility Measurement 31
at the end of one year and has put your risk level at new extremes. InNiederhoffer‘s case, he used a healthy portion of his investors’ capital tosell puts when market volatility was under 30 percent. As you can seefrom the chart below, the short-term volatility exploded to above 50 per-cent. This means that his risk greatly increased and the increased volatil-ity took what started as an “X” percent bet and brought it to a more than100 percent of the portfolio size bet. Because he bet wrong, he wiped outhis clients’ assets.
Figure 5.1
[STORICAL VOLATILITY,10 day 18.1% Last10 day 18.1% Last10 doy 10.1% Last
PCc.TVvoLATrLITtY
 
I can fully understand why Niederhoffer did what he did. I was stronglytempted to sell puts that same day (Monday, October 27). I had buy sig-nals all over the place (one day too early!) and it seemed too good anopportunity to pass.” What ultimately stopped me from taking these sig-nals was the increased volatility that continued to grow throughout theday. (On the negative side, it also stopped me from taking the trades onTuesday, therefore completely missing the correct opportunity.) WhatNiederhoffer failed to do was stop himself out as the risks grew titroughout the
* In fact, I picked up the phone three different times to call the trading desk and each time hungup without placing a trade.
 32
Chapter 5
day. What he also failed to do was adjust his position size down as the volatilityincreased. Sol Waksman, president of Barclay Trading Group, was quotedin Bloomberg as saying, “In this case, money management was entirelylacking. Any position can go against you and it is a manager‘s responsi-bility to guard against that.”
How can we learn from this lesson? By being aware of the role that vola-tility plays in risk management. For example, if you normally trade 1000shares of a $50 stock with a volatility reading of 20 percent, you shouldonly trade 500 shares of the a $50 stock with a 40 percent volatility read-ing. The dollar risks for both are now approximately the same and eventhough you cannot predict what future volatility will bring, it’s a goodbet that it won't change drastically in the near future. If it does, you mustadjust your position size to reflect the change.
As far as stop placement goes, you need to look at what the normal vola-tility is for the security you are trading. This will then tell you what theaverage likely range will be for the time period you are looking at. Forexample, let's assume you are buying a $100 stock with a volatility (100days) of 20 percent and your system tells you to be in the trade for fivedays. You would take the following steps:
1. Divide 260 trading days by 5 days = 522. Take the square root of 52 = 7.2
3. Divide the HV by #2. 20% + 7.2 = 2.7%4.
Take the stock price and add and subtract #3 from it.100 £ 2.7 = 97.3 and 102.7
This means that if the volatility remains at 20 percent, there is a two-thirds chance the stock price will be between 97.3 and 102.7 at the end offive days. Therefore, a stop placed at 99 is very likely to get hit, wherebya stop placed at 94 is unlikely to get hit.
To go further, if you then move into a $100 stock that has a volatilityreading of 35, you should not be using the same stop placement as theexample above. .
In conclusion, there is no exact science to this. Because volatility is con-
stantly changing, you must be constantly aware of these changes and actto adjust position size and stops in accordance with your risk tolerance.
  
CHAPTER 6
TRADING WHERETHE ACTION IS
Ass was mentioned in Chapter 1, one of the common traits of successfulprofessional traders is that their strategies are usually based on conceptu-ally correct principles. This means that they know how to exploit built-incharacteristics that are fundamental to the markets they are trading. Inthis chapter I point to another factor which I believe is a major key tosuccessfully and consistently profiting from the markets. This principle isthe role volatility plays in identifying the correct equities and commodities totrade. Armed with this knowledge, you will know when and why to ig-nore nonmoving markets and will understand why you should tradeonly those markets that are moving.
I begin with the concept that trading in sideways markets will chew you up.As short-term traders, we do not have the luxury of waiting for a marketto move. Because our profits tend to be small, we need to be tradingthose specific markets that provide us with the opportunity to maximizeour profits on a daily basis.
This means that unless we are trading in active markets, our likelihood oflocking in healthy profits is diminished. For example, the profit potentialis always much higher in a volatile stock like Del! Computer (DELL) thanit is in a lower priced, nonvolatile stock like the REIT, Simon Debartolo
 4 Chapter 6
Group (SPG).