Pimp My Trade

Trade Setups Based on Relative Strength or Relative Weakness

Posted on April 28, 2009 by Adam

I’m always looking for ways to increase my chances of placing winning trades. One way to tip the probabilities in favor is buying assets that are displaying relative strength and selling/shorting those that are displaying relative weakness.

What is relative strength exactly? Relative strength is the tendency of a stock, group of stocks, or asset class to outperform its peers. On the flip side, relative weakness is when that asset underperforms relative to its peers.

Let’s look at an example - we’ll use the Nasdaq and the S&P 500. Since the beginning of this year, the Nasdaq has been steadily outperforming the S&P 500. Here’s a look at a chart comparing the two indexes.

You can see that the Nasdaq is up 5% over this time period, while the S&P is down 5%. That’s clear outperformance.

If you were looking to take a bullish position in one of the indexes, you would do best with the Nasdaq. Trends of relative strength are likely to continue, increasing your probabilities of success.

But we can take that principle one step further. What if we were to choose a stock that is not only part of the Nasdaq, but is outperforming it?

Apple ((AAPL: 258.11 -1.09%)) is a great example. Over the last several months, AAPL has been a clear leader among tech stocks. In order to confirm my anecdotal idea of AAPL as a relative strength candidate, I would use stockcharts.com to try and gather some evidence.

Stockcharts.com has a great feature that allows you to chart relative strength by typing two ticker symbols separated by a colon. For example, to compare AAPL to the Nasdaq (ticker symbol $COMPQ), I would enter AAPL:$COMPQ into the ticker field and look at it on a “Sharp Chart.” What you will see is a chart that looks like this:

I have altered the chart settings slightly to make it easier to read by changing it from a candle chart to a line chart, but the conclusion is the same. The chart, which literally charts relative strength over time, is showing us that AAPL is consistently outperforming the Nasdaq Composite, which in turn, is outperforming the broader stock market.

I’m not saying it’s a great time to go out and place big bullish bets on Apple. I would much prefer to wait for a low risk setup on a traditional chart or point and figure chart to augment my relative strength analysis. When two or more of those pieces fall into place (ideally 3), that’s when I look to pull the trigger. Having relative strength behind a long trade does not guarantee success, it just increases your probability.

Don’t forget that stocks can have relative weakness, too. That’s usually the best place to take short trades, since probabilities favor lower prices.

If you really want to fine tune your analysis, you can take a look at relative strength charts in point and figure form. For a great explanation of how to analyze point and figure charts, watch the point and figure tutorial if you have not yet done so… you’ll thank me later.

Anyway, relative strength plotted on a point and figure chart will help you objectively determine when relative strength is beginning to shift. When the chart breaks one of its trendlines and begins a fresh trend in the other direction, you can bet that the trend in relative strength is starting to shift.

Case in point, Morgan Stanley. I mentioned the other day that I was taking an aggressive short position in MS. Part of my reasoning was a shift from relative strength to relative weakness, as indicated by the PNF chart. This chart happens to compare relative strength against the S&P 500. Have a look and see for yourself what I mean.

So how do you identify cases of relative strength and weakness without having to look at a ton of charts? That’s where a screener comes in, my favorite being finviz.com. Their stock screener is on freakin’ steroids and it’s completely free, which I like.

What I normally do is first screen for stocks that trade more than 200,000 shares on average to ensure sufficient liquidity. I also prefer stocks trading above $10 because I don’t like dealing with super-volatile cheapo stocks. Once I have those settings, I go to the “technical tab” and adjust the moving average parameters. To identify relative weakness, I look for stocks that are trading beneath the 20, 50, and 200 day moving averages. To identify relative strength, I look for stocks that are trading above those moving averages.

At that point, I switch to a charts view and look for appealing technical setups. I write down the ones I like the best and run some PNF analysis on them. I then take my top candidates and identify which are the weakest and which are the strongest using the relative strength analysis techniques I mentioned above and take trades based on that.

Here’s a link to a screen for relative strength stocks! Feel free to save it and use it as much as you like. To make it a relative weakness screener, just adjust the moving average parameters from above to below. I highly recommend playing around with the settings because it’s really a powerful tool.

That’s just one of the billions of ways to use the finviz screener, but that’s another discussion.

Until next time,

Happy Trading!

Technorati Tags: relative strength, relative weakness, stocks, market, nasdaq, s&P 500, technical, analysis, point and figure, charting