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Chairman Maoxian hosted a chat yesterday on relative strength and it got me thinking. It is true that RS (not to be confused with RSI) is one of the most powerful concepts in trading. But like all tools, if you want to get the most out of it, you have to know not only how to use it but when to use it.
As the Chairman mentioned yesterday, relative strength can help you to enter and ride trends (in either direction). As he further explained, a simple and systematic method is to enter on a cross over of the 13 week and the 52 week MA. Needless to say, you can use any MA you like or an alternative entry method to MA crossovers (for example, applying MACD or RSI to the ratio). Whatever entry method you choose RS can help you find trends that will persist into the future. Preferably for long, long, periods of time.
But this is its disadvantage as well. That’s because RS is not good at finding inflection points. In fact, RS would miss completely the bottoming or topping that happens before a trend change. If that is what you’re trying to catch, then you have to use other tools.
Now why in the world would you want to try and catch inflection points? Well, for starters you might be a glutton for punishment ;o) But seriously, it all depends on your style. There are myriad ways to trade profitably and no one way is the right way. It all comes down to what suits your temperment and personality:
“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”
- Paul Tudor Jones II
To illustrate what I mean, I’ll give you a relatively recent example. Take a look at the first sector highlighted in the chat: big pharma. If you were using RS to find long entries into this sector, you would have come up empty. But if you were using another set of tools, you would have seen the value proposition presented in this beaten down sector. What drew my attention to this sector late last year was the prevailing negative sentiment and the juicy dividend yield. And from among the big pharma one stock stood out for me: Merck.
Although a ‘ten-bagger’ was unlikely, the opportunity was too good to pass up for me (see comment at Trader Mike’s blog). As you may recall, back then, Merck was getting some very negative publicity over the Vioxx legal cases filed against it. Although I didn’t know what was going to happen, Merck’s stock was so beaten down and sentiment was so negative that it presented a buying opportunity.
For a recent research report, check out the ValueLine Report on Merck.
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