Finding Strong Stocks In The Market: Relative Strength Can Help

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 |  Includes: ACE, AFL, ATU, MMM
by: Michel Lahaye

What do 3M (NYSE:MMM), Aflac Inc. (NYSE:AFL), Ace Limited (NYSE:ACE) and Actuant Corp. (NYSE:ATU) have in common?

When people are looking to buy the next hot stock, they often do not search in the right places. It's a common misunderstanding that low-priced stocks always make the biggest moves. People have the tendency to think that those equities have more chance to double than higher priced ones. Psychology, dear Watson. Some traders therefore put all their eggs in risky, low priced stocks with little liquidity - a very dangerous position to be in. When a bull move is over they often notice that their stocks never gained much. Those traders that concentrated their energy and money only in the strongest names show significantly higher gains (note: trading in low-priced instruments can be very profitable but you have to really specialize in it).

To find strong stocks that are (much more) likely to double or triple with less risk I mainly use a concept called Relative Strength.

Relative Strength simply means that you are looking for stocks that outperform the general market. When a stock continues to show strength compared to the rest of the market, it has a higher chance of showing good and long-lasting rallies and this is exactly what stocks like MMM, AFL, ACE and ATU have in common.

The general thinking behind it, is that big (institutional) money always flows to the strongest names with the best fundamentals. They are not interested in taking huge risks in low-priced, illiquid stocks with their massive money bazookas.

So why bother taking the risk to invest in low-priced stocks, if you can also make decent money with the more liquid stocks that have often excellent fundamentals behind them?

But be careful while buying and position-sizing without thinking through a decent trading plan. These stocks have the probability to go higher ... but no one says they have a 100% success rate. There is no way you can control the will of the markets. So if you want to trade a concept like relative strength, you also need a thought-through plan.

How to Find Quality Stocks

There are many free websites and scanners that can automatically generate a relative strength list for you. But buying blindly of such lists is not a very good idea. It's always a good practice to choose stocks that have enough liquidity (> 500.000 average daily volume). Secondly, the stocks you select should also be priced above five dollars.

If you have too many stocks to choose from, put them in a fundamental scanner and choose the ones with the highest EPS and Sales, or select the ones that have some sector catalyst behind them.

Institutional money uses sector rotation. They mainly invest in strong and decent names and accumulate slowly into sectors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.