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Analytical Toolbox: Trading Relative Strength


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Clare White, Optionetics.com
May 1, 2009

Relative Strength [RS] approaches vary by measures used and time frames selected. The measures must be normalized so that an apples-to-apples comparison can be made. This is critical for assessing securities with significantly different prices. In addition to normalizing the RS measure, Michael Carr, CMT, suggests addressing the volatility of different securities by incorporating a standard deviation [SD] calculation to reduce overall risk.1

An outline of two RS approaches that use a shorter-term, normalized measure and a longer-term, normalized measure is provided here. In both cases a risk-adjustment is made by dividing the RS measure by the individual security's 26-week standard deviation prior to ranking the group. This particular system uses the nine primary S&P Select Sector S&P SPDR™ exchange traded funds [ETFs] which collectively comprise the S&P® 500 Index (SPX).

RS Calculation

The short-term RS measure is calculated by dividing the ETFs 3-day Relative Strength Index [RSI] by its 14-day RSI. A ratio value greater than one results when the shorter-term RSI is larger than the longer-term RSI. Those ETFs with a greater short-term relative strength are then ranked first.2 The long-term RS measure aims to capture trends that are more persistent and is calculated by dividing the ETFs 14-week RSI by its 26-week RSI. In each case a second risk-adjusted ranking is completed by dividing the RS measure by its 26-week standard deviation.

RS Signal

The RSI Ratio values are maintained daily and weekly, respectively, and the nine SPDRs ranked on Fridays (Thursday if the markets are closed on Friday). Two SPDRs are held with all four systems based on their relative rankings. The system signals are generated and implemented as follows:

RS Rank: Calculate the RSI Ratio and rank SPDRs at the end of the trading week.

Buy Signal: Buy the top two ranked SPDRs (#1 & #2) at the close on the first trading day in the week that follows (usually a Monday).

Hold Signal: Hold the ETF the following week if it remains ranked in the top third rankings (#1through #3).

Sell Signal: If the SPDR drops below a rank of 3, sell the SPDR at the close on the first trading day in the week that follows (usually a Monday).

System Results

Table 1 summarizes testing results from all four approaches over a four-year period. It assumes a $5,000 investment for each of the two ETFs and provides results that are conservative since gains did not accumulate week to week.



Table 1: Testing Results for RSI Relative Strength Weekly Signals

As expected, the approach that captures longer-term strength is superior to the shorter-term approach. The risk-adjustment to the 3-dy/14-dy RSI calculation produced inferior results since the security's volatility over the 26-week period is expected smoothed compared to the short-term strength signaled by the RS measure.

While the longer-term risk-adjusted approach produced the greatest gains, it also produced slightly more volatile returns, along with the greatest loss trade. This emphasizes the need for an additional filter for this long-only system. A variety of filters that can used in conjunction with the risk-adjustment are available once you set the RS measure for the approach and the system time-frame.

The ETF Investor

The ETF Investor is a twice monthly newsletter with an end-of-month sector strength system discussion. As technical indicators move towards more favorable conditions for a long-only approach, a robust, longer-term approach will be the focus of future issues. Variations that increase/decrease risk are also covered each month. The mid-month issue highlights two ETF trades for traders to assess.

NOTE: If you are interested in receiving a free 1-month trial to Optionetics ETF Investor, edited by Jay Kaeppel and Clare White, you can do so by clicking here.

1 Carr, M., CMT (2008). Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing. Cedar Falls, IA: W&A Publishing, (pp 123-124)

2 Carr, M., CMT (2008). Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing. Cedar Falls, IA: W&A Publishing, (p 59)

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Visit the Optionetics.com Discussion Board
  

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