How to Separate Winning and Losing Stocks in Under a Minute (using free tools)

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There is a tremendous amount of disagreement over how to conduct analysis of the stock market. The entrenched beliefs involved argue their superiority with religious fervor. I’m a simple person and highly anti-dogmatic. I want to reduce complexity and only use something because it works. Relative strength is easy to interpret and tells you important information about stocks.

The term “managing risk” has thousands of definitions. That alone can leave traders wondering if there are any rules at all. I can’t solve all the risk management problems, but I can certainly give you some tools to figure out what works for you.  Stops can often be arbitrary in nature, but increasing exposure to outperforming stocks and reducing exposure to underperforming stocks is a simple way to keep a tight portfolio.

I started out as a spread trader, and I always think about market problems from the perspective of relative value and relative performance. Some absolutes do exist in the market, but most of the data is presented in shades of grey. Relative strength analysis adds contrast to the market and helps to turn the grey a little more black, or a little more white.

Warning, this material works best with growth stocks and trending markets. I’m currently constructing a directional strategy around growth, and this post represents that. Mature stocks are often much slower, more methodical, and choppy in relation to growth stocks and should be interpreted as such.

Step 1. Go to http://stockcharts.com or any other service that can create ratio spreads.

Step 2. Enter the stock you’re analyzing and add a colon (:) and a comparable index, sector ETF, or industry ETF. Since $AAPL corresponds to $XLK, enter AAPL:XLK. $LULU corresponds to $XLY and should be entered at LULU:XLY. This creates a ratio of the stock to a comparable. When in doubt, use $SPY.

Experiment with combinations of comparable symbols to see what works for your stock. If you’re doing it right, the noise should be dramatically reduced.

Step 3. Remove all technical studies. Now, look at the chart and determine if the ratio is moving higher or lower. If it’s moving higher then the stock is outperforming. If it’s moving lower then it’s underperforming. If it’s not doing either, that’s fine. That means it’s just performing inline with the market.

Underperforming stocks are losers. Outperforming stocks are winners. Congratulations, you just performed relative strength analysis!

Step 4. Add ONE technical study that will make trend identification more systematic. Slope of moving average is good. RSI above or below 50 is good. There’s no correct answer, just don’t make sure you use only one. Next, adjust the time frame to suit your style. Weekly charts are good for long-term traders and daily charts are good for short-term traders. Intraday charts are only suitable for lunatics glued to their monitors all day.

The practical takeaway is this: If the stock is underperforming it’s peers, there’s a better place for your money. If you want to initiate a position in a certain stock, it might be good to wait until it shows some signs of outperformance before you make a purchase. Let the stock prove to you that it’s a winner, at least on a relative basis, before you take on a large amount of risk.

Bonus step: Overlay the individual stock with the ratio chart and you will see a visual representation of the hand off between your stock leading or lagging the market. This will give you insight into when the stock is overheated and when it is oversold.

Here are a couple random examples:

$AAPL - Objectively still underperforming.  Why pick the bottom?

aapl_relativestrength-jan_17_2013

$LULU – No longer racing ahead of the pack.

lulu_relativestrength-jan_17_2013

$DDD – 3D printing stocks are still working.

ddd_relativestrength-jan_17_2013


Disclaimer: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please click here for a full disclaimer.

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