Utilize a Relative Strength Strategy for ETFs

Exchange-traded funds (ETFs) have become attractive investments in recent years because they can be traded the same way a listed stock can. Investors have many ETF choices, from foreign country funds, to sectors and industry groups, to styles (eg, growth and value), to size (eg, large and small cap), and even commodities (eg, oil, gold, and silver). With some 227 ETFs to choose from, how can a physician-investor decide which to select and when to execute the trade?

Over the long term, covering several major bull/bear cycles, no stock selection strategy beats relative strength (ie, buying and holding only the strongest stocks). When a stock slips enough so that it is no longer among the strongest, sell and replace it with whatever stock is the new strongest.

The formula used to calculate and sort stocks by relative strength varies but generally measures price performance over periods ranging from hours or days for short-term traders to up to a year for long-term investors. Most investors are geared toward the longer end of this range because most people cannot meet the demands of short-term trading.

The relative strength strategy works best when concentrating on just the top 10 ETFs. The following is a sampling from a recent top-10 list:

Trading the top performers is a high-volatility strategy. The strongest stocks go up more in bull markets but also fall more during corrections. Since August 2004, the strongest stocks have suffered large declines in minor market corrections but have been very quick to spring back to the top when the correction runs its course.

"A relative strength strategy over many market cycles may be improved further by combining it with a general market timing model that sets exposure according to market risk, moving to fully invested at times of low risk or increasing cash holdings at times of high risk," says Darrell Jobman, senior analyst with TradingEducation.com.

Robert W. Colby, Chartered Market Technician, is a technical analyst at www.tradingeducation.com and www.robertwcolby.com. He is the author of The Encyclopedia of Technical Market Indicators, Second Edition (McGraw-Hill; 2002) and has been a student of relative strength for nearly 40 years.