HomeTrading NewsUsing Relative Strength to Create Better Trade Signals

Using Relative Strength to Create Better Trade Signals

Last week, I wrote to you about a persistent confusion concerning relative strength.

Traders confuse the popular Relative Strength Index (RSI) indicator with the core concept of relative strength.

It really saddens me that traders are so accustomed to the former, when it’s the latter that produces far more frequent, consistent, and ultimately profitable signals.

I’m on something of a crusade to get you and other options traders using relative strength to its full potential. So today, I’m highlighting some of the issues with RSI, and sharing how you can use relative strength to make better trading decisions.

RSI’s biggest problem, to me, is that you won’t always get signals from the indicator. A stock could be in a bull market without ever giving a buy signal.

Likewise, there aren’t always sell signals. It’s a popular indicator because it shows overbought and oversold conditions, but there aren’t really defined signals that could make it useful. Overbought conditions can get more overbought, and oversold conditions more oversold. Or, a stock that’s rallying consistently might never become overbought and a stock that’s falling might never become oversold.

That’s an easy problem to fix: You can add a moving average to the indicator.

When RSI crosses above its MA, you have a buy signal. A sell signal occurs when RSI moves below the MA. This guarantees you’ll get a signal.

But other problems with RSI mean the signals won’t be very good.

So instead of showing you how this works on a bad indicator, I’ll illustrate the idea with relative strength (RS).

Applying Relative Strength to Bitcoin

Unlike RSI, which shows rather arbitrary measures of overbought or oversold conditions, RS compares the performance of one stock to another. This is useful information. When you know which stocks are performing better than others, this can help you beat the stock market.

To understand that, let’s consider an example…

Assume you can buy one of three stocks. Stock A gained 10% in the past six months while B gained 20% and C lost 20%. The S&P 500 gained 12% over that time. Stock B was stronger than the S&P 500 while A and C were weaker.

An RS trader would buy B.

You might be saying, “this is based on past performance.” You’re right. RS is based on past performance. So is every popular technical indicator.

I’ll address that concern in a future article. But for now, I’ll just note that many academic studies have shown that stocks that beat the market in the past six months have a tendency to outperform in the next six months.

To improve on simple RS, you can also add an MA. Moving averages are flexible indicators that you can apply to anything.

Here’s an example using bitcoin…

(Click here to view larger image.)

In this chart, I applied a moving average on the relative strength of bitcoin, compared to the S&P 500.

To calculate the indicator, I compared the performance of bitcoin to the S&P 500 over the past year. That’s the green line. The red line is a six-month MA of the green line.

The strategy that emerges is simple — buy when the green line is above the red line and sell when red is above green. The RS sell and buy signals are highlighted with blue dashed vertical lines.

Bitcoin lost 55% of its value that brief bear market. With RS, the sell signal came in the first week of the decline. You could have sold 10.9% below the high with this strategy by selling at the open after the signal is triggered.

You would have bought back in well after the bottom, but that is a problem with any technical indicator and that can be addressed by using different indicators to time entries and exits.

As a trader, you may want to participate in bitcoin but worry about the downside. RS won’t eliminate the downside, but it can reduce the risk. It will also provide a new sell signal when bitcoin is outperforming stocks.

What RSI Would’ve Told You…

That chart shows the value of RS. Let’s see how a similar strategy would work with the RSI…

(Click here to view larger image.)

On this chart, I added the RSI with the same 6-month moving average. You can see that by following this indicator, you would’ve been out of bitcoin in late February 2021, around a price of $45k. This means you missed out on the run higher, which RS would’ve captured before taking you out of the trade at around $57k.

RSI also would’ve put you back into bitcoin less than a month later, for a very brief period, before taking you out again.

That’s just one specific example, but over the long run, RSI tends to whipsaw around and produces more noise than RS.

With RS strategies, you are always in the strongest performers. By avoiding weakness, whether it’s in stocks, ETFs, or bitcoin, you should be able to boost your returns and avoid the worst of bear markets.

Regards,

Michael Carr, CMT, CFTe
Editor, One Trade

Chart of the Day:
Time to Get Risky

(Click here to view larger image.)

What, did you really think the chart today wasn’t going to be about inflation?

I may be occasionally unpredictable, but not on a day where we’re recording the highest inflation since 1982.

Yes indeed, the Consumer Price Index rose 0.8% over the past month, clocking in at a 6.8% rise from a year ago.

What’s crazy to me is this was in line with expectations… Jerome Powell wasn’t kidding: it’s time to abandon any idea that these inflationary pressures will be short-lived.

Just glancing across markets, the action is mixed. S&P 500 futures jumped over half a percent on the news. The U.S. Dollar Index fell as much as 0.3%. And bitcoin rose as much as 1.8% in the 30 minutes after the data was released.

What does this all mean? Well, aside from virtually everything (save energy and food) being almost 7% more expensive than a year ago, it means that there’s virtually no reason to keep money in savings accounts or bonds. They’re guaranteed money-losers.

The message is getting out, even to folks outside investing circles, that the strategic financial move is to do what you can to outperform inflation. That’s only going to encourage more financial risk-taking in stocks, crypto, and even real estate, as people try to find more productive uses of their money.

In the short term, I can only see this as favoring risk-on attitudes.

Regards,

Mike Merson
Managing Editor, True Options Masters

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