Use Relative Strength to Filter Out Market Noise
It was 3AM on the outskirts of Cold Lake, Canada. My unit was there for a multinational exercise.
I heard the uncommon whirr of a generator in the equipment tent. That could mean two things.
I was in charge of the communications systems that connected the tanker aircraft to the fighters. If we lost power and the equipment failed, the exercise could be cancelled. The generator flipping on would be the first sign of trouble.
On the other hand, the team may have just been making coffee.
The generator ran hot enough to boil water. So when things were slow, my team liked to make espresso.
It wasn’t great espresso. It wasn’t even good. But it kept us busy, and gave us a small taste of home.
Standing outside the tent, I had no idea what the noise signified. Chances were good it wasn’t an emergency. I knew that because the fluorescent lighting in my tent was humming steadily. When the power fluctuates, you can hear a subtle change in that noise if you train yourself to notice it.
So, I ignored it. Someone would radio me if they needed me. And if I wanted coffee, I could make it anytime.
Learning to tune out the noise — and detect subtle changes in it — allowed me to focus on other, more important tasks.
And although I’m no longer stationed at Cold Lake, I still use this skill every single day…
How to Filter Out Market Noise
Noise is common in markets. It’s all the back-and-forth price moves that don’t mean anything in the grand scheme of things. Many new traders get sidetracked by it.
But skilled traders find ways to tune out the noise. They search for signals instead — significant price moves that can lead to winning trades.
This isn’t easy, though. Markets have a low signal-to-noise ratio — lots of noise and few signals.
To filter out the noise, traders can use certain strategies and technical indicators. In my experience, relative strength (RS) is the most powerful.
To understand how RS works, think about sports. The team that’s “relatively stronger” than the other wins the game. Over the course of a season, some teams and athletes display consistent relative strength. They are the eventual champions.
Stocks are similar. Some stocks will be relatively stronger than others — and those are the ones most likely to be champs.
Value investors like to argue with this. They prefer to buy stocks that are “on sale,” not the ones that are on top.
Some even quote Warren Buffett, who famously said: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
It sounds practical. Who doesn’t love buying things on sale?
However, I hate to say it, but you and I aren’t Warren Buffett. He has unique skills and access to information we don’t. Not to mention influence. News of Buffett buying a stock is often a good way to stop its firesale.
So it’s nice to study Buffett, but it’s impossible to be him.
Thankfully, we don’t need to be.
Academic studies have long supported the idea that winners in the stock market often continue to outperform. There are many studies demonstrating that relative strength works — in the market and in the arena.
Researchers have found that in baseball, the team winning after three innings wins more than 80% of the time. In hockey, the team ahead after the first period wins about 67% of the games. Similar results are seen in basketball and other sports.
With RS, we are effectively betting at halftime. We can already see which stocks are leaders. We’re simply betting they’ll continue to lead for some time.
That’s what I do in my newest trading strategy, Market Leaders.
Every month in Market Leaders, I update an actively managed portfolio of 10 assets, holding only the very strongest performers determined by a proprietary relative strength strategy.
With a portfolio consisting of only the market’s top winners, I know we can achieve better-than-average results. I know this because I ran my strategy over the past 3 years of market data, and found that it would’ve tripled your money at its peak, while only falling as much as 8.4% as the S&P 500 fell over 35% in 2020.
That’s three times better gains, with four times less risk.
And to juice our profit potential even more, I recommend regular options trades on the top holdings in our portfolio.
But there’s one big thing I haven’t mentioned yet.
This strategy is the exact same one I used in 2010 to manage over $200 million as a registered investment advisor. It’s what handed my clients returns of 48% in the two years I was managing money, vs. the stock market’s 35%.
Just like back then, the market is volatile. There’s a chance we haven’t seen the bottom of this bear market quite yet.
But unlike back then, you can use this strategy in your own account for a tiny sliver of what I charged my clients.
Click here to learn how you can get started today for only about $4 a month.
Michael Carr, CMT, CFTe
Editor, True Options Masters