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The problem with relative strength in general, regardless of what
someone uses to calculate it, is the measure of strength it gives is a
relative number only and does not mean the same thing from day to day.
For example, if the relative strength of 100 stocks is calculated and
sorted, today the top strength rating for the strongest stock might be
58 and tomorrow it might be 38. While it is true that the sorting does
rank the stocks by their relative strength, the problem is numerical
value associated with the strength is meaningless and can't be used in
a tester to determine the effectives of relative strength as a filter
for a particular trading system. At least not with the tester
available for MS.
In addition trading rules can't be written that define an entry with a
relative strength rating above X because X is a relative number.
I use the external relative strength which compares a specific stock
to every other stock in the pool of stocks being looked at. That pool
can be the entire market or 100 stocks, etc. If a stock is out
performing 98% of all other stocks last week and 98% of all stocks
this week then those two percentages mean exactly the same thing.
This is relevant because various performance thresholds can be tested
in the tester across varying look back periods to find the external
relative strength filter that is the most effective with any
particular trading system.
If someone wants to compare the relative strength of stocks to an
index like the S&P500, simply include the SPX index or SPY ETF in the
pool of stocks. All of the stocks that have higher strength than the
SPY are performing better and all the stocks that have a lower
external relative strength numerical ranking are performing worse.
This too can be tested or programmed into a set of trading rules. In
other words, someone could write an equation to ignore all trades
signals on stocks that were performing worse than the index.
I use the old SpyGlass program to calculate the relative strength.
It's now called Fire. The external relative strength calculations that
SpyGlass does are nearly identical to the ones IBD does. IBD uses a
larger pool of stocks than I do, but I have cross compared the lists
and the ranking differences weren't statistically significant.
I use the old SpyGlass because it's really the only method I've found
that has the appropriate dll's to do the calculations consistently and
correctly. I've heard someone else was writing a dll for this purpose
but so far I haven't seen one. The external relative strength
calculations in SpyGlass are about as easy as it gets.
In my various systems tests I have found that using the external
relative strength as a filter improves the performance of almost all
of the trading systems I tested it in.
However, overall the filters that I've found that have improved
performance the most are a market conditions filter that keeps the
system from trading against the trend, a prescreening of trade
candidates with fundamental and quantitative constraints like those
used by Value Line, IBD, Ford Equity Research and S&P platinum and
neural fair value screens, some sort of simple volume filter, and
finally the use of external relative strength.
Those four things had the most impact on the hundreds of trading
systems I've tested them in. Based on the results, I've written about
a simple trading system in Roy's newsletter with the test results from
those items on one system so the impact is objectively measured.
Here is a simple relative strength equation that has a look back
period of 120 bars and is weighted 40% more for the last 30 bars, etc.
When the stocks are sorted according to the numerical values coming
out of this equation, the sorted list compares very closely with other
software that calculates relative strength. Again the problem is the
numerical values have no comparative values except the relative
comparison for that day. You can use threshold values in tests or
equations as I explained before.
ROC(C,30,%)*0.4+ROC(C,40,%)*0.2+ROC(C,60,%)*0.2+ROC(C,120,%)*0.2
Based upon my trials and tests with this equation, if I just wanted to
be able to sort a group of stocks from the highest to lowest
performers over some look back periods, I would just use this equation
because it gives very similar results to all the other methods of
calculating relative strength that I could find and I bought or
programmed every program I could find that did those calculations.
Have fun! Ain't volatility wonderful...
Super
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