How to Trade Strength-Following Markets

This lesson focuses on trading techniques during periods when 1) the Spread is rising, and 2) both Relative Strength leaders and Relative Strength 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.  Traders are confident enough not only to buy into strength but also to defer taking profits in strong stocks.

Capital flows from weakness toward strength.  Relatively weak issues are sold and capital is redirected to stronger performers.

Strong stocks get relatively stronger, while weak stocks get relatively weaker.

The strongest stocks and groups advance the most.  In general, the stronger the recent relative strength of a stock or group, the better its forward performance.

Durable trends develop.  These periods offer the best opportunities for long-lasting uptrends in the overall market, sectors, groups and stocks. Review: The Supply/Demand Cycle.

Characteristics of Winning Stocks

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.

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.

The Long Ball

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.

Impact

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”.

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.

 

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