In today’s option trading blog I will discuss relative strength and weakness. This concept is critical to my trading system. Every day I search for stocks that are strong or weak relative to the market If I’m successful at identifying this trait I can build a basket of long and short positions and reduce my market risk. This is my “edge”. I can actually get the market wrong and still make money.

When I turn on my screen in the morning I hope for a big market move in either direction. I’ll bet most of you have never had that feeling. Can you remember a trade where you were long a stock (or calls) and you were horrified when you saw that the market was tanking? You bring up the quote on your stock and your heart rate returns to normal when you realize it has not participated in the sell-off. That stock has relative strength. Now imagine you have combined it with a short position on a weak stock. You bring up that quote and a smile comes to your face as you watch it dive. That is the crux of the system.

This strategy is used extensively by hedge funds. Many have a goal of making 12% a year no matter what the market does and a portfolio like this helps them achieve that. I have a few advantages as an individual that they don’t.

1. I’m willing to consider smaller less liquid stocks than they are.
2. I add my market opinion to the equation and I weight my longs and shorts.
3. I’m able to trade options on stocks that they would consider too ill liquid.
4. I can adjust quickly and not impact the price of the stock.

Their models are much more rigid and they don’t have the latitude to deviate from the trading system.

Does my method mean that I don’t bother with market analysis – no. In fact, that is where my research starts and ends everyday. I have to keep my finger on the market’s pulse and watch for sector rotation. I also weight my positions according to my market opinion. It does mean that I don’t have to compete with the largest financial institutions in one of the most liquid markets in the world. If ever there was “fair value”, it is the price of the S&P 500 futures at any given moment. My “edge” is much smaller in that arena. Even in a flat market there are stocks that are up and down 20%. That’s where I want to be.

In my next article I will define “strong” and “weak” and I will present examples. I’ll also give you some pointers on what to look for.

You need to be comfortable shorting to make this work. If you have any questions about shorting a stock or about the long/short concept, comment.

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