Smarter Investing In Any Economy: The definitive guide to relative strength investing by Michael Carr is a book from which one can learn some practical aspects of relative strength investing. Here is what I learnt from the book:
When you use a relative strength strategy for buying and selling stocks, you need a clear plan:
- Deciding which stocks to buy means you need to decide which are strongest on a relative basis compared to all other stocks.
- The first thing to do is choose a group of stocks from which you will make your selections. Broad market indices like S&P 500, NSE 500, BSE 500 are good choices.
- The next thing to do is look at percentage change over a certain period( say one month, three months, six months, twelve months)
- Then rank these stocks from the highest positive percentage change to the lowest.
- Then you could buy a certain number of stocks( lets say the top 25%)
- You recalculate the relative strength daily, weekly, monthly.
- You could sell stocks if they fall below the top 25%. This would increase turnover and increase transaction costs or you could say that you will sell if the stock goes below a certain percentage( say the top 50% of the stocks ranked by relative strength).
- You could also have a stop. Say a trailing stop of 25% from purchase price or a 3 ATR stop.
- You could also say that you will buy only if the stock trades above its long term moving average( say 200 day moving average)
- You can use ETFs, index funds, sector funds or stocks. If you use stocks it is probably wise to use some sort of fundamental screen as well( Screen 1, Screen 2)
There are many methods of calculating relative strength. I have listed them below:
1. Calculating RS as differences: This cannot be used in real life as different stocks are at different prices. You can use this method only if all the stocks started at the same price.
3. Applying RS over time: Here you can graph the rate of change(ROC) as an oscillator and buy if it is above 0 and sell if it is below 0. Or you can plot it against a moving average and buy when it goes above the moving average and sell when it goes below the moving average. This system would be profitable over the long run but there would be a lot of whipsaws.
4. RS ratio formulas: See these figures-1, 2, 3. The first two are similar to calculating RS as a normalised ROC. In figure three you can make buy and sell decisions based on trend line analysis. However this is subjective and is not recommended for most people.
5. Point and figure analysis can also be used with relative strength. Double-top/bottoms( above or below previous column) and triple top/bottom (above or below previous two columns) and trend lines can be used
11. Alpha and beta: Read this paper
13. Combining RS and Price-Cycle Position: Formula
14. Accounting for risk.You can modify the formula by dividing by standard deviation Formula. This can be used with any other formula as well.
By using the principles and the formulas one can create a relative strength strategy to invest and trade.