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Relative Strength Trading Explained

by Joel Williams

joelnwil@msn.com

This is to explain how I trade mutual funds, based on measurements of relative strength.

Definition of Relative Strength Trading

This is the definition of relative strength trading,

(1) Select a list of K funds.

(2) Select the number (N) of funds you want to hold at a time.

(3) Select the cut-off point (M), where K > M > N.

(4) Select the method of calculating relative strength.

Rank the funds in the list, where the lower number is the higher rank. This means that the funds are ranked 1 through K.

Buy the top N funds.

When a fund is ranked below M, sell it and buy the top-ranked fund that you do not already own. It is possible to have a different method of ranking for the buy and sell decision. So you would sell when the sell rank falls below M, and buy based on the buy ranking list. You might also, in order to minimize the frequency of trading, insist on a minimum number of days to hold a fund.

Predictive?

This method does not try to predict a market trend before it happens. Sometimes people analyze of the market and they say that because of certain fundamental factors - e. g. inflation, world economic problems - a certain thing will be a good investment, and will move up in the future. The relative strength method, on the other hand, only looks at a current trend and hopes that that trend will continue. It is like betting on the horse that is ahead, holding your bet so long as he is in the running, and then if he falls back, betting on the horse that has taken his place at the front. Of course, you cannot exactly do that at the reactrack.

Tools

Obviously, this method requires a computer and some specialized tools. Here are the tools I use for relative strength trading.

First, you need to have a database of funds. Fasttrack provides the database I use.

Second, you need a tool that allows you to try out different methods of ranking, and to check out the results of those methods by back testing. FastBreak is the tool I use.

Finally, for some of the things I do, it is useful to be able to generate a fake money market fund with an excessively high rate of interest. In order to do that, you need a programming tool. Trade is the tool I use. It can be used for a number of other things, such as generating signal files (files which do market timing), as well. Trade can also be used for developing trading systems.

All of these programs run on Microsoft Windows machines.

Methods of Ranking

Here are the methods of ranking the FastBreak allows:

(1) Simple ranking over a period of X1 days – which fund increased the most in price?

(2) Curve fitting over a period of X2 days, then rank by slope at the end point. You can fit a line, a quadratic, or an exponential

(3) General Anchored Momentun (MAM), which I will not describe, because

(4) Most Anchored Momentum is a sub-case of General Anchored Momentum, and always seems to work better. Here you rank by taking a ratio of a more recent Exponential Moving Average (EMA) and a longer Simple Moving Average (SMA).

I originally thought that MAM was the best method of ranking, and it certainly has advantages. In August, 1999, however, I ran a collection of tests which convinced me to use Slope, calculated exponentially. So at that point I switched from MAM to slope. I still believe that for individual stocks, MAM works better, however.

Consider the chart below with three funds plotted, normalized to 1 at the first of the 35 day period. They are imaginatively labeled X, Y, and Z. If you did a simple ranking (which fund went up the most) over the 35 day period, clearly Z wins out. On the other hand, if you do a slope ranking over the last 5 days, then any method of curve fitting (linear, quadratic, or exponential) will prefer fund X, since the slope at the end point will be the greatest. Longer periods of ranking will give different results, depending on the length of the ranking period, and the end point.

Now consider funds X and Z over a longer period, but starting at the same time. The 10-day simple moving averages are also drawn. Remember that MAM ranks a fund on how far above its simple moving average it is. So after Z has made its big move around day 30, it is clearly going to have a higher MAM rank. But it levels off shortly thereafter. It is probably the case that any method of ranking that is not very long term will be fooled by the sudden increase of Z, and prefer it around day 30 over X. Yet buying at Z at that point yields a smaller gain than buying X. This is just one of the difficulties with this kind of ranking; yet it still usually gives excellent results.

Generating a List of Funds

The next question is how to determine a list of funds to trade.

First, it is important to trade no-load funds that do not have a penalty for selling the fund before holding it a certain number of days (a “back-end” charge). The more funds in your list the better, even though it will take your computer a longer time to develop a system. Be sure to include foreign funds.

The best source I know of for information on fund characteristics, loads, fees, etc., is Microsoft Investor. In addition, fund information can be found at Yahoo Financial.

Be sure that all the funds in your list are open to new investors.

Two caveats, however.

The Rydex Sector funds do not seem to mix well with other funds of any kind. Develop a separate system for them.

I have never developed a system to trade the ProFunds that works. Adding the ProFunds in with your other funds, however, seems to work well.

Back Testing

The great thing about developing a system using a tool like FastBreak is that you can try various parameters over various periods of time, and then see which ones give you the best results. So when you are using a system you developed, you know that the odds are on your side. That is critical. I hear a lot of people predicting the market. How often have they been right? What are the chances that a given trade will be successful? What are the key parameters used to make the decision? What happens if you change those parameters? You can answer those questions. Can the market gurus?

Another thing you can do with FastBreak is to create an FNU file which tracks your strategy just like it was a fund in the Fasttrack database. Then you can display it and compare it to other strategies, funds, or indices.

Money Management

It is best to use a broker like Waterhouse that allows you to trade a collection of mutual funds from different families. Using Waterhouse, you can trade, for example, from a Rydex fund into a Janus fund without transferring money from one account to another.

Here are the rules:

When trading from one fund to another fund in the same fund family, the trade in and out takes place at the close of business.
When trading from one fund to a fund in a different family, the trade takes place in two stages: a sell on one day and a buy on the next. So you are in cash for one day, OR - as I just found out (11/20/99) - Waterhouse will allow a close of business sell and a buy of another fund with 90% of the current value of the fund you are selling. For example, if you have $10,000 in X and want to switch it for Y, you can sell all of X and buy $9,000 of Y at the same time. The next day you will have about $1,000 in cash with which to buy more Y.

On the other hand, if you are in a margin account (assuming that the funds are marginable), you can essentially make the switch as of close of business on one day. However, you do not know the exact amount of money you will get from the sale of the first fund, so you have to approximate.

How many funds should you own? Generally, one fund is fine – you will see better results in your backtesting if you develop a system that holds only one fund. However, it is probably not wise to put more that $200,000- $300,000 into any one fund if you are trading actively. The fund company may frown on quick trading of large amounts. I do not know of any actual cases, but I do not feel like risking it myself.

How much should you have to begin trading? There are a large number of mutual funds with a minimum of $2,500 initial trade. So I would say you could safely be in one fund out of that list if you started with about $3,000. Often the IRA minimum is $2,000. Of course, a one-fund system is likely to be more unstable than a 3-4 fund system.

Time

How much time does this take? Often people say that they simply do not have the time to trade mutual funds, or anything else. This is utter nonsense, and some of the people that have said this are living experts on re-runs of Lost in Space, or have memorized all the lyrics of the Red Hot Chili Peppers, so they do not get any sympathy from me.

So long as there are no net problems (and there seldom are), here is the schedule:

Download the Fasttrack database – 5 minutes at most (after 7:30 Eastern Time).
Run any Trade programs you may have developed for signals, etc. – 5 minutes should be plenty.
Run your FastBreak systems to see if any trades are called for – 5 minutes at most.
If trades are called for, log onto Waterhouse or whoever you are using, and input the trades – 10 minutes (the Waterhouse site is very slow, even after hours, so you may find this takes a bit more time if you are trading several accounts).

So there you have it: about 25 minutes every night at most - usually much less. Or go to bed early, and do it in the morning while watching CNBC. Lost in Space is on later on the Sci-Fi channel, and you can watch the Red Hot Chili Peppers on MTV while inputting your trades.

How long does it take to develop a system? One or two weekends at most, when you are beginning. So hire somebody else to mow the lawn and work on your systems. It is money well spent.

Results???

Of course, good results cannot be guaranteed. If you optimize a system over a period of several years when the market has done very well, and you get a backtested result of, say, 50% per year, you cannot expect to get 50% every year. What you gain through the development of a system is a way of making decisions that has worked in the past. The next year you might get 60%, or you might even lose money. It all depends on the market conditions. After all, if the best fund in your family only goes up 5%, you can hardly expect to do much better than that.

Finally, I give you the following manifesto - just to get you fired up.

Manifesto: Yes, You Can Beat the Market

Buying an index fund because "most managers do not beat the market" is just an admission of defeat.

Pick a fund whose manager that is significantly beating the market at the current time, and stay with that fund so long as it is doing well

Believing and trusting in any fund manager is a mistake. Sometimes they are hot, and sometimes not.

Do not get emotionally involved with a fund, its philosophy, or its manager, no matter how good they sound on CNBC. Performance is all that matters.

Paying a load or a redemption fee for a fund is just plain stupid.

Need I say more?

Asset allocation is nonsense; bonds are almost never a good buy.

Some people say you should always have some money in bonds, and provide complex asset allocation models for you to follow. But consider this: When interest rates are going up, it is a mistake to buy bonds because you will lose some of your principal; when they are going down it is very likely that the equity market is going up at a faster rate than the bonds are appreciating; so the only time to be in bonds is when interest rates have peaked, and will stay at that level for some time.

Diversification is for wimps and weak minded idiots.

Some people recommend that you have a diversified portfolio: sector funds in most of the sectors, a large cap fund, a small cap fund, a mid-cap fund, a value fund, and a growth fund. Then you are supposed to judge the funds by their "peers". So this year (1999) you would be keeping the best of the "value" funds, which is, of course, doing worse than even a mediocre growth fund.

Listen to what the fund manager says - NOT!

True, sometimes this is instructive. But consider Robert Sanborn, manager of the Oakmark Fund. For the last 2 years the fund has been a real dog, or Donald Yactman whose 2 funds are down more than 20% this year. They say (according to an article in Investors Business Daily 12/9/99) that the problem is "short-term investors who don't grasp their funds investment methodology." Listen, dudes, I don't give a rat's ass about your investment methodology. I want to make money, and you are doing a bad job of that. So expect nothing from me. And maybe you should get a job more in line with your capabilities, like licking stamps.

Give the fund some time - NOT!

Again, from the same Investors Business Daily article, quoting Ed Foster: "I would only bash a fund if it inderperformed its benchmark peer group in each of the 1-, 3-, and 5-year time periods." " It's not fair to dump on a fund manager just because he underperformed the market for a short period of time." Fat chance I would ever hold a fund for even 1 year if it were underperforming the market, much less its peer group.

There is a sucker born every minute, but it does not have to be you

There is a lot of really bad advice out there. For example, Gardner Brothers (Motley Fool) have this idiotic buy-and-hold mentality, and they recommend just buying an index fund. Many people will take that advice, and it will cost them money. But it does not have to be you. Paine Weber raised $2.1 billion for one of its funds because its brokers got extra-high commissions for selling it. But you did not even have to listen to those brokers. The guy who brought us the LTCM crisis has raised a bunch of new money from "wealthy individuals and institutions". But you can do better with your money, and avoid those institutions.