Buy High And Sell Low With Relative Strength

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Buy High And Sell Low With Relative Strength

The relative strength (RS) approach is a popular and effective tool for evaluating one investment to the whole market, whether you have $1,000 or billions. However, few people ever master the concept because they fail to integrate RS into a holistic trading plan.

In this post, we define relative strength, explain why it works, and show how individual investors may use it. This adaptable tool may be used to analyze equities, exchange-traded funds (ETFs), and mutual funds.

Relative Strength

The purpose of investing is to sell something at a better price than the investor paid for it. The challenge for investors is identifying whether prices are low enough to signify a purchase and high enough to indicate a sell.

This issue is addressed by relative strength, which quantifies how a company performs in comparison to other equities. The goal is to purchase the best stocks (as assessed against the overall market performance), keep them while capital gains build, then sell them when their performance deteriorates to the extent that they are among the worst performers.

Relative strength has long been recognized as a useful investing strategy. In Edwin Lefebvre’s 1923 classic “Reminiscences of a Stock Operator,” Jesse Livermore observed that “[prices] are never too high to begin buying or too low to begin selling.” In other words, firms with strong relative strength are expected to continue rising in price, and Livermore believes that buying such stocks is preferable than buying equities with dropping prices. Since Lefebvre’s time, there have been several disputes on the best technique to determine exactly when prices are high, compared to one another, and when they are low.

H. M. Gartley’s “Relative Velocity Statistics: Their Application in Portfolio Analysis,” published in the April 1945 edition of the Financial Analysts Journal, contains one of the earliest quantitative computations of relative strength. Gartley wrote the following to compute velocity statistics:

First, it is necessary to select some average or index to represent the broad market, such as the Standard & Poor’s 90-stock Index, the Dow-Jones 65-stock Composite, or a more comprehensive measure…The next step is to compute the comparable percentage advance or decline of the individual stock in the swing…And finally, the percentage rise or decline in the individual stock is divided by the corresponding move in the base index and multiplied by 100, to give the “velocity rating” of the stock.

Velocity ratings are closely related to beta, the Nobel Memorial Prize-winning concept developed by William Sharpe. These stages also clarify the fundamental concept of relative strength, which is to compare an individual stock’s performance to that of the market. There are many methods for calculating relative strength, but they all end up gauging a stock’s momentum and comparing it to the whole market.

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It would be more than 20 years after Gartley before another research on relative strength was released. Robert Levy released a thorough article in 1967 that proved definitely that relative strength works (or at least that it did during his test period of 1960-1965).He looked at relative strength across different time periods and then looked at future performance of equities, finding that those that had done well in the previous 26 weeks likely to do well in the next 26 weeks.

Applying RS

To calculate relative strength, we may divide the six-month rate of change in a company’s price by the six-month rate of change in a stock market index. If IBM has increased by 12% in the last six months and the market, as measured by the S&P 500, has increased by 10%, we obtain a value of 1.2. This style of graphic is seen below.

A monthly chart of IBM with its six-month relative strength shown in the bottom portion. Image by Sabrina Jiang © Investopedia2020

As seen above, buying and selling purely on RS trendline breaks would have been a lucrative long-term strategy. Buy signals are represented by up-pointing arrows. The sell signs are heading downward.

Because RS is best implemented over a weekly to monthly time period to minimize whipsawing, a monthly chart is provided. In this example, buy signals are generated when RS breaks a downward sloping trendline, and sell signals are generated when RS breaks an upward sloping trendline. This method would have needed just three productive purchases over a 15-year span.

A more prevalent use of RS is to rank order all stocks in a certain investing universe.

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The initial step in any ranking procedure is to compute an RS value. While the basic rate of change calculation works well, some investors prefer to utilize a beta or alpha, which is a concept connected to beta. The approach employed is not as crucial as implementing the formula consistently. Weekly rankings are required to maximize earnings and, more importantly, to avoid losses.

Profiting From RS

The concept of rating equities based on RS may assist small investors in managing their retirement plans. As part of a whole pay package, many firms provide their workers with a retirement plan. Many self-employed people have retirement plans because they provide tax advantages and are an essential aspect of an individual’s overall financial planning. While conventional pension plans gave workers a proportion of their yearly earnings after retirement, growing costs caused businesses to transfer the responsibility of retirement funds to employees, resulting in the defined contribution plans now provided by the majority of corporations.

Employees in a defined-contribution plan contribute a part of their entire salary to an IRA. Part of the contribution may be matched by the employer. The entire payments are invested, often in the stock market, and the investment results, which may result in wins or losses, are credited to the individual’s account. When you retire, the sum in this account will provide you with retirement income.

The majority of these self-directed retirement programs provide tax benefits. In compensation for the tax breaks, the government imposes severe withdrawal limitations on retirement savings before you reach retirement age. As a result, retirement funds are really long-term assets and should be handled accordingly. Long-term management makes these accounts ideal for implementing a relative strength strategy, which seeks market-beating profits while accepting risk.

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If we suppose that the company provides a standard variety of investing alternatives, a dozen distinct mutual funds may be accessible. Each week, the investor may compute the six-month simple rate of change for each investment choice as well as a market index to actively manage this account. The RS trader would invest the whole account balance in the fund with the greatest value.

RS may also be used to determine when to sell and when to acquire something else. To prevent whipsaws, you might keep the fund when it is rated first, second, or third. If it falls to No. 4 or below in a given week, it should be sold and the money used to acquire the presently rated No. 1 fund. When using more than 12 funds in the computation, the cutoff rank may be adjusted between 25% and 50% of the total number of investment alternatives.

Conclusion

Test findings from studies like the one done by Robert Levy demonstrate the advantages of relative strength and demonstrate that this approach is worth investigating. Because a relative strength approach can be utilized inside a retirement account, it is even more accessible to the typical investor, and it can be employed by anybody wishing to take an active part in managing their finances.

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