This lesson focuses on trading techniques during periods when 1) the Spread is rising, and 2) both RS leaders and RS laggards are rising. These strength-following markets have not only been the most profitable, but have also been the most prevalent over the last fourteen years. During that generally very bullish period, the market was rising in a strength-following mode nearly 30% of the time.
Here are the most important features of rising, strength-following markets:
Traders are confident enough not only to buy into strength but also to defer taking profits in strong stocks.
Relatively weak issues are sold and capital is redirected to stronger performers.
Relatively weak issues are sold and capital is redirected to stronger performers.
In general, the stronger the recent relative strength of a stock or group, the better its forward performance.
These periods offer the best opportunities for long-lasting uptrends in the overall market, sectors, groups and stocks. Review: The Supply/Demand Cycle.
To paraphrase the old saw about real estate, the three most important features to look for in a purchase candidate during strength-following periods are relative strength, relative strength, relative strength. Strong stocks attract new capital, and the strongest attract the most.
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Besides relative strength, here are other features to look for in good trading candidates: New all-time high price. Stocks at or near new highs have little or no overhead supply; there are no get-even sellers to impede the upward progress of the stock's price.Either a large base of accumulation or a period of consolidation under the stock. During strength-following periods, many strong stocks are advancing out of long periods of accumulation. Even though price may be well above accumulation levels, these bases are the foundation for substantial moves and offer the trader some indication of probable targets (see: Point and Figure Charts). Alternatively, strong stocks may exhibit long-term uptrends, with no nearby long-term accumulation. In these cases look for consolidation (reaccumulation) of the long-term trend to provide a base from which another upleg may be launched. Not overbought. Avoid new purchases of grossly overbought stocks. Wait until an overbought condition eases. Even strong stocks will tend to correct an overbought condition by reacting or by consolidating gains. On the other hand, do not liquidate your entire position in a strong stock merely because it is overbought. Strong stocks may become overbought numerous times during an advance. If you have liquidated your position, it is psychologically very difficult to chase a strong stock once it moves. Beyond your exit price. If you do take profits, maintain at least a partial position to avoid that "locked out feeling". If the stock's technical condition is still otherwise favorable, rebuild your position once the overbought condition passes. Finally, an oversold condition may not be relied on to help you identify good entry points, since the strongest stocks--and therefore the best candidates--often have some difficulty becoming oversold. Waiting for a strong stock to become oversold is like waiting for wild horses to return to the corral once they have broken out. |
Over the last fourteen years, the market has provided traders with an opportunity to hit the long ball less than one third of the time. It is an opportunity that should not be missed. When the pitch is fat--slow and down the middle--do not bunt or chip the ball for a base hit. Swing away. Rising strength-following markets are a time for doubles, triples and even the occasional home run.
Rising, strength-following markets trend exceedingly well. Take advantage of long-lasting trends by extending your time and price horizons. If you normally trade intraday, trade multi-day price swings. If you are a swing trader, consider holding your position over multiple swings by waiting out minor corrections and consolidations.
If you use leverage, this is the best time to employ it. Leverage comes in two forms. There is, of course, the brokerage margin account. But there is another form of leverage, volatility, which is intrinsic to each stock. Highly-leveraged stocks move more (in either direction) as a percent than other, less highly-leveraged stocks.
One gauge of volatility, beta, measures the amplitude of a target's swings about a statistical axis. I do not recommend use of beta as an indication of a stock's intrinsic leverage, since a highly-leveraged stock which is trending well may exhibit only a modest beta.
Here's a simple way to measure a stock's leverage that overcomes this drawback: first, calculate the average percentage covered by the daily range, from low to high, over some period, say, six months. Next, compare that average range to the average range of the benchmark by taking the ratio of the target's average range over the benchmark's average range. We shall call the result "Impact".
Target's Average Percentage Range/Benchmark's Average Percentage Range = Impact
This ratio indicates the impact which, by dint of leverage, a stock makes on a portfolio. A ratio of 1 indicates that the target's impact is equal to the benchmark's. The higher the impact, the higher the leverage. An impact of 2 is about average for stocks (the impact of the average stock will always be more than the benchmark's because of the "diversification effect" on the benchmark).
All things equal, higher-impact stocks should be considered favorably during rising strength-following periods. High impact produces extra lift under the long ball.
Note: Leverage also introduces added risk. Before using leverage of any kind, make certain that you are adept at risk management. Review: How to Lose.
This lesson focuses on trading techniques during periods when 1) the Spread is falling, and 2) both RS leaders and RS laggards are rising. Rising contrarian markets are nearly as prevalent as rising strength-following markets, but not, on average, as profitable. These markets are, in the main, more difficult to trade. During these periods, traders take profits in RS leaders and retreat to RS laggards. Strong stocks are sold, and weak stocks receive new support. As a result, the overall market is likely to be choppy, and durable trends in individual stocks are less likely to develop.
Here are the most important features of rising, contrarian markets:
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Traders are risk averse. Traders' preference for sold-out laggards demonstrates that confidence in the trend is weak, even though the broader market is rising. Capital flows from strength toward weakness. The weakest stocks and groups advance the most. stocks which have a recent history of weakness advance more than stocks with a recent history of relative strength. Apart from that general observation, however, relative strength--or weakness--does not provide a reliable guide to those individual stocks most likely to do best. These periods are often transitional. Bottoms are being made, or the broader market is consolidating, or the market may be in transition from bull to bear. Periods during which the Spread falls may set up either a new round of strength-following or a substantial correction. Review: Reading The Spread Durable trends in individual stocks are the exception. |
Traders are picking up bargains, which means RS laggards are picking up new sponsorship. New capital flowing into such stocks will show up as improved relative strength. Look for laggards with Worm charts indicating simultaneous improvement of both offense and defense. Review the Worm chart of the Europe Group in The Worm.
Laggard stocks which have been ignored during previous market advances may now begin to attract attention. These laggards will have built up long bases of accumulation.
Overbought/oversold indicators can be used effectively to filter candidates for purchase. Oversold stocks on or near solid support are the best candidates. However, do not remain in oversold stocks which continue to act sluggishly or which do not show improving relative strength.
indication is a signal to stop, look, and listen. If an advancing stock exhibits climactic action or high-low compression on increased volume, reduce your position. Contrarian markets are trading markets. Take profits.
Rising contrarian markets are a time for base hits and bunts. With few exceptions, stocks do not trend well, but trade in short bursts. Consider shortening your grip on the bat for quicker response. If you normally trade multi-day price swings, trade intraday. If you are a position trader, used to holding your position over multiple swings, consider trading each swing independently.
Reduce leverage. The odds of success are lessened by a falling Spread. Your ratio of losing to winning trades is almost certain to rise. Throttle back on trading size to reduce potential losses.
Since the profit potential of each trade is reduced during rising contrarian markets, it makes good sense to tighten up on loss control. Play strong defense. Review: How to Lose
For traders who exercise good risk management, selling short is no more risky than taking a long position. On the other hand, since stocks and commodities tend to fall faster during bear markets than they rise during more bullish market phases, properly executed shorts can be very profitable.
During bull markets, there is constant rotation from sector to sector and group to group. And above all, there is rotation from laggards to leaders and back again. Rotation presents occasional opportunities to sell short, even during bull markets, though the odds of success are greatly improved if short sales are confined to periods when the trend of the broad market is down.
As a general rule, it wise not to sell short unless both leaders and laggards are trending down. At the very least, both leaders and laggards should be trending lower below their respective twenty- to thirty-day moving averages. Short-side returns are best under those conditions (review: Playing The Odds).
Good short candidates will exhibit these key features:
Such distribution is likely to be characterized by high volatility, high volume, and trendless price action.
Even though an extended downtrend may not be clearly in evidence, selling pressure is often made evident by a tilt lower in the overall price pattern.
After a period of distribution, an issue will indicate it is ready to move lower by moving lower. Shorting before there is a clear demonstration of weakness can be hazardous.
Once a target has offered a clear sign of weakness, wait for a rally back to supply before entering orders to short. Such a rally should show signs that bulls are exhausted. Light-to-moderate volume and gappy price action are often features of weak rallies. The approach of the target to a zone of former supply is likely to produce increased selling. These sellers are your allies, and their selling will protect your position against an extension of the advance. Short as close to overhead supply as possible.
Over the first half of 1998, Mckesson (MCK) extended its advance of the previous year to a price just above 90. The stock then corrected to support around 75 before building a base (A). Twin terminal shakeouts below the support line, A, set up a strong rally to a new high around 95 (B). So far, indications are bullish. However, a sharp break on increased volume (C) puts us on alert. The stock is unable to hold its new high, and the urgency of the selling indicates that something is amiss. We suspect that the basing and subsequent rally to a new high are part of a campaign to distribute stock. However, the push at C does not break support at A. We watch carefully for more evidence of distribution and/or weakness.
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