How To Use This Simple Market-Beating “Edge” To Score Massive Gains
Today, I’d like to touch on one of the most important concepts that too few investors know about or use themselves.
I’m talking about momentum investing.
You see, some investors tend to have a negative perception of momentum investing. They somehow think it’s “beneath” them. It’s probably because we’ve had the “buy and hold” mantra hammered into us as the only way to invest. But nothing could be further from the truth. In fact, when done properly, momentum works surprisingly well…
Longtime readers know that my preferred method of momentum investing is based on the idea of “relative strength”.
There are a number of ways to do this. Some prefer to scan for things like Rate of Change (ROC), for example. Others, use a method in which stocks are ranked against each other over various time frames.
And as you might have guessed, I have a preferred way of doing this, too. But to understand relative strength we first need to look at momentum investing in general.
Understanding Momentum Investing
Some academics explain the behavior of the markets with the Efficient Market Hypothesis (EMH). They believe markets efficiently price stocks using all available information. The strictest form of the hypothesis says that no individual can beat the market because each stock is trading at exactly the right price at all times.
Despite the theory, they noticed that some investors do beat the market. And after further review, they found that there are some exceptions to EMH. Among the anomalies: value and momentum.
In its most basic form, momentum investing is simply buying stocks when they go up and selling when they start to go down. But as easy as this sounds, historically many momentum investors have struggled with exactly when to sell.
They either hold on for too long and watch their gains return to zero, or they cut their winning positions too early, causing them to miss out on even bigger gains.
Another problem early momentum investors faced was not having a clear idea of what to buy next. This tends to lead to simply chasing the latest hot stock tip (in other words buying high and selling low.)
Relative strength (RS) allows us to incorporate momentum investing into a complete investment strategy. With RS we can set clearly defined buy and sell signals. It takes the emotion out of the investment process, which has proven to be the bane of most investors’ existence.
Understanding Relative Strength
I like to explain RS with a sports analogy. In any game, the winner plays in a way that is relatively stronger than the loser. If you were trying to select the winner before the game started, you would probably pick the team you thought was the stronger of the two. That might be the team with more wins or the team that enjoys an edge in some way for the upcoming game.
Investing is like a sports game in that there are winners and there are losers. RS is a tool that quantifies which stock is stronger (has the most wins this season) and is, therefore, more likely to keep winning. But it actually gives you an even bigger advantage.
Because most stocks have a fairly extensive trading history, selecting a winner is actually like picking a team after the game is already in progress.
Researchers have found the team that is ahead after three innings in a baseball game wins about 80% of the time. In hockey, the team ahead after the first period wins nearly 70% of the time. A college basketball team that is leading by at least eight points at halftime wins 80% of the time. In each case, the team that has the stronger start is likely to win in the end.
Just like in sports, we want to pick the stock that has been winning in the past because it has a better chance of winning in the future. RS allows us to quantify who the leaders are right now. And studies confirm that those stocks tend to outperform the average stock in the future.
A Legitimate “Edge” For Investors And Traders
Over at my premium service, Maximum Profit, we specifically look for stocks with RS above 70 over the past six months. This means that they have outperformed 70% of all other stocks during that period. This ensures we’re holding only the best-performing stocks.
For example, in May 2020, I told my subscribers about a company called Sea Limited (NYSE: SE).
Based out of Singapore, the company has grown into a dominant force in Southeast Asia. It operates through three segments with a ton of growth potential: Digital Entertainment, E-Commerce, and Digital Financial Services.
Think of it as the “Amazon” of Southeast Asia.
When we added it to our Maximum Profit portfolio on May 1st, it sported a RS rating of 96. That’s incredibly strong. Combined with the other elements of my system, SE was a no-brainer buy. You can see what happened next…
Now, a 317% gain is nice. But remember, we also use relative strength as one of our sell signals over at Maximum Profit. So when the momentum began to fade for SE, my followers and I got out.
As it turns out, the stock went on to make new highs after that. But eventually, it came crashing back down to earth.
There’s an important point here. Yes, we would have loved to score even more gains with SE. But can you honestly say you would have avoided that crash and kept all your gains?
I’ve been doing this for a long time, and I honestly can’t tell you whether I would have been able to keep my gains without this system.
Again, ranking stock performance based on six months is the method I prefer. But if you want to try this on your own, you may prefer to tinker with the time frame or narrow your rankings to a specific index. And there are a number of screening tools out there that can help you employ this strategy. It’s up to you.
The point is, relative strength is one of the few true edges available in the market. And if you’re willing to change your mindset and embrace momentum stocks (by using RS, for example), you can make a lot of money.
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