Using Relative Strength in Trading

09/11/2009 12:01 am EST

Focus: STRATEGIES

Trading is one of the most fascinating, challenging, and rewarding businesses on earth. Very simply, we are looking for price patterns that have high odds of follow through, then we look to the market internals to see if it makes sense to enter a bullish or bearish trade, and, if acceptable, we calculate share size per our trading plan, enter the trade, and then enter management mode. When looking for stocks to trade in a particular sector, it is best to trade the cleanest patterns that are showing relative strength for longs (and relative weakness for shorts).

There are various ways to determine strength. Some include comparing the stock to the sector, comparing it to market internals, or comparing it to itself. For example, if the SMH (semiconductor holders trust) has a bullish daily, gapped up, and is a buy setup into the gap fill on the five-minute chart, but AMAT also has a bullish daily, also gapped up, but is basing at the high into the first reversal and did not pull back, it is showing relative strength to the market. Now assume the S&P futures pulled into the gap fill on the five-minute chart (and the TICK fell and the TRIN rose), but both SMH and AMAT also have a bullish daily, also gapped up, but are basing at the high into the first reversal and did not pull back, then they are showing relative strength to the market internals.

Finally, many novice traders believe that a stock’s relative strength indicator (RSI) measures relative strength to the market. Remember, the RSI, like any oscillator, is a derivative of price and volume, and therefore, all compare stock action to itself, not to a broader market index. So RSI measures the momentum of a stock’s price action compared to its price “x” periods ago (default is 14 days), but to the Pristine-trained trader, offers no benefit that is otherwise not readily ascertainable from price action.

In addition to watching my long and short lists for possible entries, I watch two market minders looking for relative strength or weakness. If the market gaps down, and I am considering fading the open and looking long, I see what is showing relative strength compared to the broader market. Similarly, if the market gaps up and I am looking for a short, I will focus on the weak stocks, which are those down at the open that did not participate in the market’s gap strength. (Note that this is a short-term, countertrend strategy that is applied only when the market internals suggest it. In fact, we might actually be buying the stocks that gap up with the broader market, either on pullbacks into the first reversal period or over a 30-minute high.

By Avery Meizner of Pristine.com

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