Trend Trading For Dummies

by Barry Burns

Publisher: For Dummies

Release Date: September 2014

ISBN: 9781118871287

Chapter 19

Using Relative Strength to Make

More Money
In This Chapter
 Looking at what trends are hot and which are not
 Watching strength signals to determine your move
 Being the first to the party (of the trend)
I explain in Chapter 18 that buying into a market that’s overly popular will normally get
you in late to the party and often just before the market turns around. However, it doesn’t
mean that you should ignore such markets. They can still present significant
opportunities, just in the opposite way most people would guess.
In this chapter, I show you how to spot trading opportunities, using the concept
of relative strength, which is the measurement of the strength of one market relative to
the strength of another market. (Note: The term relative strength, as I use the term in this
chapter, has no correlation to the Relative Strength Index [RSI] often included in the list
of indicators of charting software platforms.)
Knowing how to use relative strength may enable you to find potentially great trading
opportunities early and at a good (low) price.

Finding What’s Hot Now

The use of relative strength can help you choose which market is likely to offer the best
opportunity in a new trend. In this section, you find out how to measure relative strength
and how to a read a relative strength chart in order to spot the hot trends.

MEASURING RELATIVE STRENGTH

As I mention earlier, relative strength is the measurement of the strength of one market
relative to the strength of another market. For example, when two markets are moving up,
one is moving up with more strength.
The major U.S. stock indexes normally trade in concert with each other. In a sustained
uptrend of the stock market, the DOW, S&P 500, NASDAQ, and Russell 2000 all trend
up, but one moves up faster than the others.
 In Figure 19-1, both the S&P 500 (the thicker line) and the DOW (the thinner line) are
moving up. However, at their last value on the right side of the chart, the S&P 500 has
more relative strength than the DOW.

Figure by Barry Burns

Figure 19-1: The S&P 500 is slightly stronger than the DOW.

 Not all trends are created equal. Some are stronger than others. The strongest
trends make you more money, so those are the ones you want to trade.
After you’ve established the trend of a market, determine which subset of that market you
want to trade by measuring relative strength. Here’s how:
1. Plot the two markets you want to compare on a chart.
Have them start plotting on some date in the past (on a daily chart, I’ll often have
them begin plotting 90 days prior to the current date).
2. Use a percent change chart for both markets.
Instead of measuring how much the markets move up or down in price, a percent
change chart measures what percentage the markets move up or down from the
starting point you set.

READING RELATIVE STRENGTH

You can read the relative strength chart in a crude manner as I demonstrate earlier in
Figure 19-1.
At first glance, you may think that whichever market is higher is the one that has the
superior relative strength, but that’s not necessarily true. More accurately, you need to
observe how the two markets are moving toward or apart from each other. If one market
is moving farther apart from the other to the upside, then it’s gaining in bullish relative
strength.
Figure 19-2 shows a time when the company Apple, Inc., (AAPL) was outperforming the
S&P 500, as illustrated by the thin line (Apple) pulling away from the thick line (the S&P
500).
 After outperforming the S&P 500 for a few weeks, Apple then had a sharp change in its
relationship with the S&P 500 and clearly underperformed, as illustrated in Figure 19-3.

Figure by Barry Burns

Figure 19-2: Apple is outperforming the S&P 500.

Figure by Barry Burns

Figure 19-3: Apple is underperforming the S&P 500.

Using the terms outperforming and underperforming are from a bullish perspective of

the market. In other words, you use them when looking to buy the market. However, if
you’re bearish — that is, you believe the market is going to go down — you can use the
terms in the opposite direction.
A market can be moving away from another market to the down side and thereby have a
superior bearish relative strength, which could be a good signal if you want to execute a
short sale.
 One line pulling away from another isn’t the only way to read a shift in relative strength.
After one line has been moving away from the other and the spread between the two lines
diminishes, it also demonstrates a shift in relative strength between the two markets, as
illustrated in Figure 19-4. Here, Starbucks Corporation (SBUX) has superior relative
strength (and is thus outperforming) to the S&P 500, even though the line representing it
(the thin line) is below the thick line of the S&P 500.

 The spread between the two lines diminishing doesn’t necessarily mean that the
two lines are angling toward each other. They both may be moving up, for example,
but the distance between them is getting smaller. In this case, the market represented
by the market of the bottom line would be gaining in relative strength over the
market represented by the top line.

Figure by Barry Burns

Figure 19-4: SBUX is outperforming the S&P 500.

To help read the relative strength between the two markets, I add an indicator that
measures the spread, or difference, between the two markets. To do so, you choose one
market as your benchmark (I’ve been using the S&P 500 in the examples in this section)
against which to measure other markets. If the line of the spread indicator is trending
down, then the market you’re measuring is declining in relative strength against the
benchmark (underperforming).
In Figure 19-5, both the S&P and Halliburton Company (HAL) are moving up, and it
may not be clear whether Halliburton is outperforming or underperforming the S&P 500.
However, by looking at the spread indicator, which is trending down, it becomes clear
that Halliburton is actually underperforming the S&P 500.
If the line of the spread indicator is trending up, then the market you’re measuring is
increasing in relative strength against the benchmark (outperforming), as illustrated in
Figure 19-6.
Figure by Barry Burns
Figure 19-5: The spread indicator is trending down, showing underperformance.

Figure by Barry Burns

Figure 19-6: The spread indicator is trending up, showing outperformance.

Getting in Early While the Iron’s Hot

As with most things in trading, you want to enter early in a new directional move to make
your reward as large as possible. Trading shifts in relative strength is the same. You want
to get in early before everyone else does and before the move in your direction is over.
You also want to make sure that you’re not too aggressive interpreting relative strength
shift signals that may turn out to be false signals.
In the following sections, I show you how to determine when to get into a trade using
relative strength signals and how to reduce your chances of taking relative strength
signals that will fail.
 KNOWING WHEN TO ENTER ON RELATIVE STRENGTH
SIGNALS
Looking at the spread indicator in Figures 19-5 and 19-6, you may notice a lot of wiggles
up and down. The spread indicator doesn’t just move in a straight line, but, much like bar
patterns on price charts, it “wiggles” while it trends up and it “wiggles” while it trends
down. Therefore, I draw trend lines on the spread indicator, and the first signal I look for
to enter a shift in relative strength is a break of the trend line, as shown in Figure 19-7.
Another signal I look for to enter a shift in relative strength is a new higher high or lower
low on the spread indicator, as shown in Figure 19-8.

PROTECTING YOURSELF AGAINST FALSE RELATIVE

STRENGTH SIGNALS

 Like all other technical analysis indicators, I never rely on the measurement of
relative strength alone in making trading decisions. It’s just one among many other
energies I consider when taking a trade. It provides an opportunity to consider
entering a market precisely because using it effectively could help you outperform
the S&P 500, which is the benchmark that many fund managers are measured
against. Watching the spread indicator is another way of trading the trend. Rather
than the trend of a single market, however, it’s the trend of one market in relation to
another.
As wonderful a tool as the spread indicator is, I can tell you from experience that it gives
many false or very short-term signals. The best way to avoid those false signals is to pull
up a chart of the market that appears to be starting to outperform the S&P 500 (or
whatever benchmark you’re using) and analyze that chart on the basis of the five-energy
methodology (see Chapter 14).

Figure by Barry Burns

Figure 19-7: The break of a trend line on the spread indicator.
Figure by Barry Burns
Figure 19-8: The first lower low on the spread indicator.

 Only trade a market that’s beginning to outperform your benchmark when you
get a legitimate setup confirmed by the five energies in the market you want to
trade.

Buying What No One Else Wants — Yet

An exciting way to use relative strength analysis is to find value plays in which you can
buy a stock at a bargain basement price. Instead of trading markets that are outperforming
the S&P 500, look for those that are dramatically underperforming.
Trading out-of-favor markets is a contrarian approach that may bring great rewards by
getting you in before everyone else, thus helping you catch a major market move.
In the following sections, you examine the advantage and disadvantage of getting into a
new directional move early.

JUMPING IN EARLY ON A TREND

A famous saying among traders is, “The trend is your friend until the end.”

 Waiting for too much confirmation of a trend before jumping onboard isn’t such
a smart move. The longer a trend continues, the closer it’s getting toward its end. So
you want to enter a trade before the market has moved too far and nearly all those
interested have already entered.
Another way to look at that same saying is, the longer a trend continues, the more likely it
is to reverse and begin trending in the opposite direction! That gives you the opportunity
to jump early into a new trend because the trend is clearly established and seen by
everyone else.
 This principle is the same one behind trading trend reversals on price patterns, and it’s
also the idea behind trading relative strength trend reversals.

RISKING BEING FIRST TO JUMP

Trading trend reversals is one of the most risky setups to trade. When it works, and the
market begins a trend in the opposite direction, it’s the best reward-to-risk ratio trade
possible. However, catching the very end of a trend is notoriously difficult to do;
therefore, while the reward-to-risk ratio is wonderful, the win/loss ratio is typically very
low.
Don’t get me wrong: You can trade trend reversals successfully, but it often takes several
attempts to truly get in at the end of a trend. The only way to survive multiple failed
attempts in the process is by implementing excellent money-management and risk-
management techniques.
In addition, even if you manage to catch the very end of a trend, there’s no guarantee the
market will reverse and trend in the opposite direction. Many trends simply end with the
market consolidating or evolving into chaotic movements for long periods of time.
Finally, this type of trading requires tremendous patience, perfect discipline and nerves of
steel. It’s certainly not for most people.
The correlation between risk/reward ratios and win/loss
ratios
Professional traders are extremely disciplined at monitoring their performance and monitoring their
numbers. Two of the most important numbers measured are a trade’s risk/reward ratio and win/loss
ratio. Traders talk a lot about what those ratios hypothetically should be. However, what you really need
to know is what those ratios actually are in your own trading.
You may hear the risk/reward ratio defined by the amount you’re willing to risk on a trade against the
profit target you have for the trade. That’s hypothetical, and in the real world of trading, it’s critical you
work with your own real numbers. You need to know your own risk/reward ratio, which is the average
per trade dollar amount of your actual losses against the dollar amount of your actual wins.
The win/loss ratio is simply how many of your trades make money over the number of your trades that
lose money.
With both ratios, you should also factor in commissions for a realistic number. I know traders who show
a positive value in one of both of the ratios, but it turns negative when commissions are factored in.
There are four possible scenarios for your trades:

 You have a better than 50/50 win/loss ratio, and you have a better than 1:1 risk/reward ratio. This
scenario is ideal, and it’s what I constantly strive for.
 You have a better than 50/50 win/loss ratio, and you have a worse than 1:1 risk/reward ratio. You
can be a successful trader with these ratios. This is typical of scalpers.
 You have a worse than 50/50 win/loss ratio, and you have a better than 1:1 risk/reward ratio. You
can be a successful trader with these ratios. This is typical of pure trend traders.
 You have a worse than 50/50 win/loss ratio, and you have a worse than 1:1 risk/reward ratio. You’re
in trouble!

Track your ratios continually. Analyze both your winning and losing trades and always beworking on
finding ways to improve both ratios in your trading.