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Trader-Socrates asks, in response to this post of relative strength leaders:

What kind of RS do you use? What timeframe you mean by “short-term” RS?
I am sure, that you know, that research shows, that short-term (up to several month) is mean reverting. Would love to hear your thoughts. Big thanks in advance.

Good questions here. There are a few issues to consider, but remember that was not intended to be a list to be blindly bought. Rather, it is a starting point for idea generation. You are also correct in what you say about mean reversion, which is why looking to buy names on that list that are showing some consolidation (a visual representation of mean reversion) can be a good strategy. Let me round this out with a section from my book:


 

If you choose to develop a systematic trading plan based on relative strength, you will also need to consider the impact of mean reversion. Consistently buying the strongest markets will often have you buying overextended markets that are poised for at least a temporary reversal. Depending on how you rebalance your portfolio and actually execute, you could potentially then rotate into the new leaders after booking losses on the first set, and repeat this process as long as capital allows. Systematic approaches to relative strength are possible, but these issues have to be addressed in development and through proper backtests. There is also a lesson here for discretionary traders: though you may want to focus much of your attention on relative strength leaders, blindly buying them is probably not a path to success.

There are many ways to track relative strength. The simplest is probably to simply take a number of markets and rank them by percent change from a fixed point in time, but there are a few potential issues with this simple measure. Most importantly, this measure is anchored to two specific points in time, and is blind to anything that happens in between. One market could appreciate 10 percent in a series of steady gains, while another could have extremely volatile swings and just happen to end the evaluation period also up 10 percent…

Choosing an arbitrary look-back window is not always a good choice, since the rate of change (ROC) calculation is also sensitive to what happens at the initial point. To standardize, it is possible to anchor the calculations to a fixed point in time, and to calculate changes for a wide range of related markets from those points. Significant swing highs and lows are ideal anchor points for this calculation… A limitation is that, if we want to compare relative strength across disparate asset classes, it is usually impossible to find a significant anchor that makes sense for all of them. Why compare, for instance, European equities, grains, sugar, and cocoa to the same starting date, and how is this better than picking an arbitrary starting point?

One potentially attractive solution averages several different rates of change, perhaps with different weightings. Using a system like this, it is possible to create a measure that has a very long look-back window, but is also very responsive to recent data. Bill O’Neil has long been an advocate of such an approach, which has been used with some success in his funds and his writings. Traders who are interested in this concept can begin by simply averaging two different rates of change, comparing relative strength rankings, and then tweaking the measure via weightings or the addition of other look-back periods in the average…

Trading Relative Strength

Though the concept of being long the strongest markets by relative strength and short the weakest is sound, there are the twin forces of mean reversion and range expansion to consider. A campaign of simply buying the strongest markets will usually result in frustration, as your entries will often be at the apex of overbought markets. At the risk of oversimplifying, most successful relative strength trading programs follow some pattern like this:

  • Understand the overall market trend, and decide whether you want to trade from the long side, the short side, or both. If trading from both sides, decide whether you wish to construct a true hedged portfolio or simply to hold both long and short positions as you deem them attractive.
  • Identify the strongest and weakest relative strength candidates.
  • Look to buy the strongest relative strength candidates, but buy them on weakness and using specific technical patterns as triggers. Conversely, look to short the weakest markets into strength.
  • Once the leaders have been bought on weakness, monitor them carefully as they turn out of the weakness to see if they resume leadership. If not, exit or adjust the trade. If the weakness continues for too long, the leaders will no longer be leaders.

The actual execution of buying into weakness is not as difficult as it sounds—use the general technical rules for buying pullbacks, but every piece of the puzzle matters: the relative strength measure, the frequency of evaluation/rebalancing, the actual execution triggers, whether you are executing off simple charts or spread charts, and your intended exit strategy. Change one part, and the others will have to adjust as well, as there is usually a fairly small sweet spot where everything comes together and the system works reliably. As long as you understand the core concepts, do your homework, and understand how these concepts play out in your chosen market, you can build a strong trading program around these ideas.

Realize that relative strength leaders are usually a large group, and there is generally rotation within the group. In the case of stocks, there may be 50 to 150 different names vying for leadership on the rallies. In the case of the commodity metals, there may be only four to 10 names in the sector, but relative strength may pass between two or three of those regularly. The point is that you cannot say that “XYZ is the market leader” and then abandon XYZ the first time you notice another name has edged XYZ off the very top of list. In addition to its actual ranking in any quantitative scheme you develop, the trading patterns and integrity of trends in the leaders are also important considerations…