We have discovered one technical analysis trading indicator that stands heads and shoulders (pardon the pun!) above every other commonly used technical indicator, pattern, or tool.
In fact, when this technical indicator is combined with a single fundamental factor, its stock picking power is truly unmatched.
While nothing is guaranteed when it comes to investing in the stock market, these two pieces of data can sharply tilt the odds of success in your favor.
Nearly every modern day trader uses technical analysis to make buy and sell decisions in the stock market. At the same time, most active traders lose money.
Traders and investors blame themselves for not understanding technical analysis, misapplying it, and a host of other reasons.
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The truth is that most technical indicators simply do not function in the way many investors expect. In fact, most indicators don’t work at all.
When its all boiled down, technical indicators don’t predict what will happen, they merely tell you what has happened. It is then up to the investor or trader to interpret the signal as neutral, buy or sell.
In other words, when used in a vacuum, the odds remain 50/50 on every investment entry even when indicators are used properly.
The key word here is vacuum. Nothing works as a stand alone tool in a vacuum when it comes to investing
Technical trading is best when it is used to compare stocks to each other. This comparison is done with a technical indicator called Relative Strength.
By using Relative Strength, stocks can be compared with each other so you can choose the strongest performing stocks of the group.
It’s just not my experience that proves the value of Relative Strength. Numerous academic style studies have reached the same conclusion.
A noted example is James P. O’Shaughnessy, in his “What Works on Wall Street,” book he documents a study of 46 years of stock market history. His study makes clear that Relative Strength significantly outperforms” the stock market.
The research revealed that using a relative strength-based system would have beaten the market by an average of just under 4% per year since 1932.
The way Relative Strength is used is to use it to screen for stocks with a reading of 70 or above. This means that these stocks are ‘stronger’ than 70% of their market or index group.
Contraian investors believe the opposite. This means that they think that readings above 70 indicate “overbought” conditions, therefore signaling time to sell. While this can make sense during certain conditions, we have found that buying strong stocks makes more sense most of the time.
Active traders use Relative Strength charted on a price chart as a real time technical indicator.
- The RSI moves to a lower bottom, price lifts to a higher bottom.
This type of pattern is generally discovered in a price uptrend after price corrects from a sell off. You can think of this as a bounce from the lows. When the RSI sets a lower bottom and price sets a higher bottom it means that the uptrend or bounce from the lows will likely continue higher. In other words, this is a trend continuation signal.
- Price and the RSI create equal or higher bottoms.
This pattern is also a continuation pattern. The uptrend will likely continue higher just like the example above.
- The RSI creates a higher bottom while price moves to a lower bottom.
This pattern is usually seen at the end of an uptrend. It is a reversal pattern meaning that the upward trend is expected to soon end.
All this can be wrapped up by stating that price will likely move higher if there is a divergence between price and the oscillator. In addition, if price and the RSI bottoms converge in an uptrend, the uptrend is likely to continue.
These signals generally work best during medium term price reversals during the medium term trend. The best way I have found to determine the medium term trend is the 20 period simple moving averages.
If price is above the 20 day simple moving average but still below the 50 day simple moving average, the trend can be thought of as medium term.
As in all technical trading, not every trade taken based on price, oscillator divergence/convergence will be a winner. In fact, you may take multiple losses in a row before finding one that actually works profitably.
This is why stops are so important when trading the medium term. Stops keep you in the game long enough so that your system will work in a profitable way for you. If you do not use stops, one bad trade can ruin your trading.
I like using trailing stops that follow the price move at a certain distance locking in profits and allowing them to accumulate. Most trading platforms have trailing stops features built directly into them.
Obviously, long term traders don’t want to sit and watch charts all day. Therefore the best way to use Relative Strength is to screen for stocks trading at 70 or above in Relative Strength.
Use this list of stocks as your watch list for further research.
Now, the next metric that truly takes technical analysis and Relative Strength to the next level is known as free cash flow yields or FCF.
The greatest investors in the world use FCF as a primary valuation metric. When FCF is combined with Relative Strength is creates an unbeatable stock picking combination!
Uber investor Warren Buffet has been quoted as saying the following about free cash flow:
“[O]utstanding businesses by definition generate large amounts of excess cash. —Warren Buffett letter to shareholders from 1984
However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash. –Warren Buffett letter to shareholders from 1980
Investopedia defines free cash flow this way:
A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as:EBIT(1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital ExpenditureIt can also be calculated by taking operating cash flow and subtracting capital expenditures.
The easiest way to calculate free cash flow is by minusing capital expenditures from operating cash flow.
Investors want to drill into the high Relative Strength stocks for names that are steadily increasing their FCF.
The reason this works so well is that increasing free cash flow is often a signal for increasing earnings.
When the news of the increasing earnings hits the wire, we all know what should happen! Everyday investors will look to buy into the stock, while savvy investors who use Relative Strength and FCF will already be in for the ride higher.
Certainly company’s have tricks up their sleeves to artificially inflate the FCF numbers. Investors need to look out for dirty tricks like dishonesty in accounts payable, selling receivables, non-operating cash and shady accounting practices.
Therefore, not every time FCF is steadily increasing does it signal a strong company. Use common sense and your knowledge of the sector to unearth corporate trickery.