Irrefutable Law of Trading Success #3: Relative Strength Leads the Way

The 10 Irrefutable Laws of Trading Success... Law #3: Relative Strength Leads the Way. The concept of relative strength is one of the most time tested, most reliable of all the concepts that you can use in your trading. The concept of relative strength has different facets to it, different aspects. First of all, there is the relative strength of any market versus other competing markets. For example, let's say that we look at a sector and we might look at the energy sector and in the energy sector we could look at, we could look at West Texas crude from the United States. We could look at Brent crude from Europe, we could look at heating oil, we could look at unleaded gasoline, we could look at gas oil from Europe, those are all major contracts and they're all highly correlated. One of the best techniques is to look at all five of these and see which one is the strongest and which one is the weakest. In other words, rank them from one to five, one being the strongest, and five being the weakest and then quite simply, what we want to do is we want to just buy the strongest and sell the weakest. If we want to go long, we want to buy the strongest. Let's just say in our argument, let's say that Brent crude is the strongest, let's say West Texas crude is the second strongest, gas oil is third, heating oil's fourth, and unleaded gasoline is last. Okay, so there's our ranking one through five. Now, we said that Brent crude was the strongest. If we want to be long something in the sector, we want to buy the strongest, or buy the second strongest, so we want to be long, Brent crude, or long West Texas crude. If we wanted to be short, we'd want to sell the weakest, we would sell unleaded gasoline being the weakest or maybe heating oil being the second weakest. 

Now, why do we want to do this? Well, one of the things is that if we engage in trend following, what we see is the strongest relative strength names have the cleanest trends. If we buy Brent and it's the strongest, what we'll see is that the pull backs in Brent will be a lot smaller, might not even have any. Brent might actually instead of pulling back, it may go to a range and just work sideways. This is important, because one of the most important aspects of trend following is to make sure that you can stay in your trend. If I'm long the strongest, what I'll see is I don't really have setbacks, I don't really have pullbacks, the market just kind of goes up and go sideways and goes up and goes sideways. Where if I'm on the weakest, if I'm long, unleaded gasoline, it may still go up because they're correlated. All of them may be going up, but unleaded gasoline may rally and then have a big break and then rally and have a big break and rally and have a big break. It might still go higher, but it might do it really in choppy fashion. This makes it very hard to hold. These deep pull backs knock you out of the trade. That's why we want to be long the strongest, the strongest relative strength name. If we want be short, we want to be short the weakest. So maybe they're all going down, but unleaded gasoline is the weakest, so if we sell unleaded gasoline, we'll see it'll break and it'll pause, and it'll break and it'll pause. Again, there's not sharp pullbacks, there's not a deep pullback, so it makes it much easier to hold your short. If Brent was the strongest, like we said, and all of them were going down, and I sell Brent. I'll sell it, I'll get some feedback and it'll come flying back and stop me out and it'll break again and they'll come flying back. It's very difficult to hold. 

Within a sector, understanding always what is strongest and what is weakest, it can have a massive impact on the success of your trading. Now we could go beyond a sector and we can look at the broad market. In the broad market. We want to be buying the names that are strongest, and selling the names that are weakest. This is one of the things that's at the heart of the Investor's Business Daily method. Buying the strongest relative strength names, selling the weakest and they rank them. A stock that has a IBD relative strength of 99 means it's in the 99th percentile over the last year of all names. It is strong. What the research shows is, every time we have a bull market, the bull market is not driven by all the names. The market itself is driven by just a handful of names, just a handful of sectors, those names make up the entire bull market, which means that all the other names, the 1000s of other names really are going nowhere. Look what's going on right now. You have a handful of names, everybody's talking about The Magnificent Seven. Those are the big seven stocks and they're talking about AI, particularly big cap AI. Right, so we have NVIDIA, we have META, we have Netflix, we have Microsoft, those names are all big, Google, those are the largest names and they have been giving us the majority of the gains. 

If you find the relative strength names, those names tend to outperform everything else. If we can find the weakest relative strength names, those names will suck more than everything else. If we just scan, see, one of the problems is people have too many signals. They get overwhelmed. They don't know what to trade because there's so many buy signals or so many sell signals. This is especially the case in stocks. But when we use relative strength, we can quickly narrow down to just a handful of names, the names to focus on for longs, the names to focus on for shorts. This makes us much more efficient, much more focused, and has us trading the best names. Relative strength leads the way. If you work with us, you'll hear us talk about this all the time. We're always looking at relative strength, relative strength across the market, relative strength across sectors, relative strength inside of sectors. We changed the format a little bit this week. We're experimenting going away from the PowerPoint. We've showed you lots of graphics in the past, but today, I'm just talking with you, explaining what I'm thinking. We're excited to get your feedback on what format you like best, because we want this to be great for you. Now, as you know, every Tuesday I come to you at Trader Tip Tuesday with techniques like we're talking about today with relative strength that are designed to help you take your performance to an elite level. Check out relative strength, and I will see you next Tuesday.