Updated: Jan 13
Momentum trading strategies favor using the trajectory of prior price action to determine where prices may be heading next. Those same strategies can be potentially enhanced by adding another layer of information: relative strength.
I don't mean relative strength as in the relative strength index technical indicator, though. Instead I'm looking at the relative strength (or weakness) of one asset vs another, often broader comparison.
Demonstrating relative strength: XLE vs SPY
For example, the energy sector is outperforming the S&P 500 this year, and we saw a resurgence of that strength begin anew in late August. As we saw relative strength build, it provided a signal that perhaps there was a rotation happening underneath the surface, where allocation was heading into energy and out of other areas of the market.
A ratio chart of XLE vs SPY
The colon between the two symbols means you're creating a ratio chart. To use a different sector simply substitute the sector ETF name.
Another view of relative strength
We can also measure relative strength by comparing how sectors are performing against their
peers over various time frames. I tend to favor 1-week, 1-month, and 3-month time frames as we can see if the outperformance trend is healthy and continuing.
S&P 500 sectors: three month performance
For example, over the last three months we can see that XLE was up 19.58%, clearly the strongest of any of the 1 1 S&P 500 sectors.
This relative strength vs other sectors helped to further demonstrate that the above ratio chart was showing us a rotation out of other parts of the market and into energy.
Energy has been the strongest performer this year, with XLE rising nearly 70% year-to-date.
Strong oil prices in 2022 have given the sector a tailwind it continues to enjoy.
Navigating strength-driven trades
There are a lot of thoughts from many great traders about just when to exit or enter. Some use indicators, others use price action or key levels, and I've also seen, and used, some incredible backtested strategies. What works for you is going to vary depending on your personality, risk profile, goals, and trading style.
I tend to favor a combination of backtesting and chart watching for scaling into and out of these trades, as well as defining my risk tolerance. For example, our partner TrendSpider has a good backtesting scripting language as does TradingView. These scripting languages can allow us to run tests on various signals and strategies going back years or even decades.
In backtesting, it's important to look for both entry and exit signals, with the latter having a bracketed approach, whereas one may either stop out or hit a target.
Because backtesting is a deep topic with a lot to cover, I will plan to write a separate article with more details on strategies worth exploring.
Defining risk tolerance
When trading momentum it's important to quantify the stop, as the ultimate target may be a bit elusive if we are following a strong trend. That is to say, we may be long or short until we feel the trend reached an end.
When setting a trailing stop on a momentum play. one quick and dirty technique is to let volatility help you define risk threshold.
For example, if we take implied volatility add it to realized volatility and then divide the total by 32 that percentage is often a reasonable expectation for what day-to-day volatility may look like.
Let's use XLE as an example. Currently XLE 1-month implied volatility is 33.3% and realized over the same time period is 33.4%.
If we are doing the math, it looks like this: (33.3 + 33.4) / 32 = 2.084375%, with realized combined with implied volatility suggesting that we can expect daily swings just over 2% in XLE.
As a result, when placing a trailing stop we should ensure it is wider, otherwise we're likely to get booted out of the trade during routine chop. I would typically add a full percentage point, so for my XLE trend trade I'd set the trail stop at 3.084%.
Wrapping it all up
This article is meant to serve as a primer about relative strength momentum trading, and there will be another article coming up about backtesting in order to define entry, exit, and better define risk.
I'm happy to answer any questions you may have. Just post them in the comments section here or the #questions channel on our Discord server for Traderade+ members.