How to Design Your Own Relative Strength Trading Strategy

Relative strength (RS) is widely followed by professional investors. Their interest in RS is simple to understand – their job is to beat the market and the stocks with the highest RS are the ones beating the market. Professional investment managers cannot do their job without owning high RS stocks. Using strategies that include RS helps them meet their goal.

Despite its widespread acceptance among market professionals, individual investors rarely follow RS. Again, their interest level is simple to understand – RS is difficult to find for individual investors. In the past, this indicator has only been available with expensive subscriptions. Many investors believed it could only be custom programmed using expensive software. This has now changed. Recently, a useful RS indicator has been made available for free. And, it really is possible to program a simple RS strategy in spreadsheet software like Excel or the free spreadsheet available in GoogleDocs.

Before turning to the question of how to apply RS, we need to define the concept.

As investors, we usually think in terms of absolute returns. With this mindset we might say a stock did well if it gained 10% in six months. Relative strength puts that return in context by comparing it to other investments. If a stock gained 10% while the S&P 500 gained 20%, the stock did not do well. It underperformed the market or was relatively weaker than the market. Relatively stronger stocks would have returns that were more than 20% in this environment. RS measures the relative performance of a stock, ETF or mutual fund and shows which stocks beat the market.

For the past fifty years, academic researchers have been publishing studies showing stocks with high RS tend to outperform the market in the future. Each study is different but in general terms they all follow the same steps:

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  1. Calculate the performance of each stock or fund in a group. The group could be the entire market or a smaller group like the mutual funds available in your employer-sponsored retirement plan.
  2. Sort the list based on performance from high to low.
  3. Buy the best performers and hold them until they are no longer among the best performers. Some studies sell short the worst performers but shorting stocks is not necessary to beat markets.

If RS is high, that means the trend of the stock is most likely up. When RS turns down, the strong uptrend is over and you should sell. That’s it in a nutshell; RS is just a way of buying stocks that are going up and selling them when they are going down.

Academic studies have found RS could beat the market by more than 5% a year on average. If the market averaged a 10% return you could expect 15% gains with what the academic community calls momentum strategies. Since the early 1990s, academic researchers have called RS “momentum.” They actually call it “the momentum anomaly to the Efficient Market Hypothesis (EMH)” because the EMH says you can’t beat the stock market and momentum allows you to beat the market. Rather than revising the EMH, researchers called momentum an anomaly and now say you can’t beat the market unless you use a strategy based on an anomaly.

The chart below is typical of the results in the academic literature. It shows momentum stocks (the purple line) beat small caps (the line marked “size” shown in red) and value stocks (the green line). Notice how consistent the outperformance of momentum has been.

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RS became popular among traders in the 1990s when the Investors’ Business Daily newspaper included the indicator on its charts. Their calculations were proprietary but from the academic literature we know there at least a dozen ways to calculate RS. One of the simplest is to take the percentage change in price over the past six months and rank the stocks from highest to lowest. The strongest performers in the past six months are likely to beat the market in the next six months.

The founder of Investors’ Business Daily, William O’Neil used a baseball analogy to explain RS. He asked if you were managing a baseball team would you rather have a lineup of hitters with a batting average of .300 (which is considered excellent in baseball) or a team of .200 hitters (mediocre players)? Most managers would want .300 hitters but there aren’t very many of them. The same is true in the stock market. Stocks with an RS score of 70 or higher are the best players and there aren’t very many. Just 30% of stocks will be in this range.

Recently, StockCharts.com introduced an RS indicator they call SCTR, the StockCharts Technical Rank. This is more complicated than the six-month price change. Six different indicators measuring long-term and shorter-term performance are calculated and weighted for each stock. The raw values for all stocks are then sorted from high to low and the highest ranked stocks are given the highest SCTR scores which range from 0 to 99.99. Stocks with SCTR scores above 70 would be buys.

You could use SCTR, or RS, to help make decisions on when to buy and sell. You could buy when RS moves above 70 and sell whenever SCTR at StockCharts.com falls below 70. That rule would have helped you avoid significant losses in Apple (Nasdaq: AAPL).

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When the RS rank falls below 70, that indicates the stock is no longer in the top 30% of all stocks ranked by performance. RS is telling you that there are better opportunities elsewhere in the market. That’s really the purpose of RS. This indicator points you to the very best investment opportunities.

As you can see in the chart of AAPL, RS is not a short-term strategy. You would have held your position for about a year and a half and nearly doubled your money. This is a technical tool long-term investors can use to minimize their risk. To minimize trading, you could even hold positions until RS falls below 50. For long-term investors, there is rarely a reason to hold stocks with an RS rank in the lower half of the market.

RS can also reduce risk in retirement plans with few investment selections. You could complete the required calculations yourself and create your own RS trading model.

Let’s say your retirement fund includes six ETFs as options – an S&P 500 index fund, a small cap index fund, an international stock market index fund, a bond index fund, a Treasury bond index fund and a money market fund. This is similar to the choices offered to federal government employees. Every week, you calculate the 26-week price change for each ETF and sort from high to low. You buy the top-ranked ETF. When that ETF falls to second place in the rankings, you sell it and buy the number one-ranked fund. This process is repeated every week.

The results are impressive. You wouldn’t have beaten the market but you would have avoided the worst of the bear market in 2009. In this case, your return since 2003, the year when we had a sufficient history to begin testing with ETFs, would have averaged 9.19% a year, just below the market average of 9.44%. But your largest drawdown would have been 22%, much less than the 55% drawdown of the stock market. This means you probably would have been able to retire on your schedule rather than having to work an extra three or more years after the bear market.

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Returns are low in this model because it uses conservative ETFs. RS models usually do better when selecting volatile stocks. The next chart shows the results of a similar RS strategy applied to the volatile stocks tracked by Investors’ Business Daily in their IBD 100 list. Since the bear market bottom in 2009, the strategy has gained about 275%. As the chart below shows, your account would experience a great deal of volatility and this system wouldn’t be suitable for conservative investors.

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Here the rules are a little more complex because we have 100 stocks to choose from. We are buying the ten stocks with the highest rank and selling when their RS score drops below 70. Whenever we sell, we have room in the portfolio so we buy the stock that has the highest RS score that isn’t currently in the portfolio. These are the type of rules used by professional investment managers and academic researchers. To implement an RS strategy, they always buy the highest ranked stocks and sell, or cast off the stocks, when they fall below some RS rank which is also called a “cast off rank.”

It is possible, but difficult, to implement this strategy for 100 stocks with a spreadsheet. Tracking six or twelve ETFs in a spreadsheet would be a relatively simple task for most investors.

RS should be a part of your trading toolbox. You could use it to time buys and sells, as we saw with the example of AAPL. It can be used to minimize risk if your employer offers only a few options for your retirement plan. Or, RS can be used as a complete investment strategy.

At a minimum, you should consider looking at a chart with RS plotted to help you time entries and exits in individual stocks.