According to statistical analysis and based on over 20 years of trading experience, I can tell you without hesitation that very basic relative strength analysis between two related stocks or other assets is one of the best market timing methods that you will find.
I’ve said it many times before and I will say it again, but there is absolutely no correlation between higher profit or higher percentage of winning trades when using complex technical analysis indicators compared to very simple ones.
Often times, traders confuse relative strength analysis for RSI which stands for relative strength index. The former is simply a method of comparing strength or weakness between two assets, while the latter is an oscillator that’s based on math formula’s and measures overbought and oversold levels. There is no similarities between these two analysis methods, so please don’t confuse the two because of the similar names.
To give you a better understanding of relative strength analysis between two different assets, let’s do a simple example, so you can actually see the steps that go into applying relative strength.
The first step is to select two related assets, the industry group or the sector if you are using stocks is not that important; what’s important is the similarity between the two assets.
In our example we will compare the relative strength of Coca Cola and compare it to Pepsi Cola and will choose the stronger stock out of the two. In this case, we are simply comparing two assets, but you can compare the relative strength of several assets against each other using the same method that I’m going to show you, if you want to determine which asset out of a large group is the strongest or weakest one.
I typically look at the last 2 to 4 months of percentage change of each stock and see which one had the best performance during that time period.
In the chart below, you can see how Pepsi Cola (ticker PEP) gained .58% over the past two trading months.
In this in the chart below, how Coca Cola performed over the past two months, which is about 40 trading days. You can see that the asset lost value over the past two months. The stock lost .85% in the price of the asset, while Pepsi Cola, gained .58% in value.
Based on this very simple relative strength analysis, I would conclude that Pepsi Cola has better relative strength in comparison to Coca Cola, at least over the past two trading months. And statistically, the stronger asset continues outperforming, so I would buy Pepsi instead of Coke in this particular case.
Now that we’ve figured out which stock we would buy out of the two choices, we have to figure out how to select the best options contract to take advantage of the potential upside price move.
There are two fundamental questions that can help us determine which strike price we should buy and how much time value we should give the option before expiration.When contemplating any type of options strategy, we have to take into account the fact that options lose value with time and one of the most important factors to take into account is how much time the asset realistically needs in order to move up to the desired price level.
For relative strength trades, I prefer to purchase options that are approximately 90 to 120 days out of the money and always roll the option over when the time period till expiration reaches anywhere between 60 and 50 actual days. I want to make sure and liquidate the option before it begins losing substantial time value, in addition to Delta becoming so low that the the option fails to react like the underlying asset.
The second factor that we have to determine is which strike price to buy. Under most circumstances, when initiating net long positions, which is what we are doing in this particular case, we want to have the least amount of implied volatility impact the price of the option and the best way to do that is to buy options that are at or slightly in the money.
Implied volatility impacts speculative options that are further out of the money, than options that are closer to being in the money and hold substantial intrinsic value, as a general rule, because the more actual or intrinsic value the option actually holds, the less implied volatility will impact or distort that option; deep out of the money options, suffer the opposite fate and are greatly impacted by implied volatility, since there’s much more speculation involved in the future price of these options. Because the value of these options change substantially more in terms of pure percentage, these options attract much more speculative activity, which is what causes implied volatility to rise and fall quickly.
In the example above, comparing Pepsi to Coke, the price of Pepsi stock was around $96.50 per share. I would look for call options with a strike price between $93.00 and $96.00, if I was in search of a a call option for this particular relative strength trade. You don’t need to go very deep in the money, but a few points does help reduce implied volatility associated with the option the majority of the time.
Lastly, don’t forget that relative strength analysis works to the downside as well or better than the upside, since markets fall much faster than they rise the majority of the time.
You would simply compare relative weakness between stocks to determine the weakest asset out of the two or more possible choices and then initiate put options instead of call options.
All other factors that I discussed in this article would apply equally to the short side of the market, so don’t be afraid to take advantage of bearish market opportunities. You will find that your overall portfolio volatility and risk will decrease and your gains will increase.