For the past week or so I have been trying very hard to find strategies that make sense and can offer diversification. I previously talked about countertrend/mean reversion but frankly, I have not figured out the proper fundamental basis for these type of systems. Why? Well the logic behind these countertrend sytems are totally opposite to that of trend following. Also, I don’t feel that countertrend sytems are robust enough which can stand the test of time. They seem to be fitted to certain markets rather than approach a wide variety of markets.
Then came Relative Strength (RS / Momentum) systems. After reading about it more for the past few weeks, “aha” just seemed to happened. The concept of RS makes a lot of sense, buying strength. And also there are significant acedemic evidence showing that it is profitable. What is relative strength?
Initially when I heard about it through a few research papers by formula research, I brushed it off thinking that it is a top and bottom picking strategy. The name Relative Strength…seemed very familiar to Relative Strength Index hence the confusion. Not did I found out now that the concept is radically different and is widely practiced by many hedge funds and pension funds.
Relative: a comparision between two similar things
Strength: stong, power
Really, it is a comparision between different markets (ie different stocks). The measure is usually momentum and takes the form…(Xt – Xa) where “t” and “a” represents different time periods. There are different measurement of momentum and I would let the reader decide which is better through testing. After the comparison, the other major thing is ranking. The idea behind ranking was explained in the previous post. Ranking the momentum values will ensure that you will only take signals from the best. The next thing is really your imagination. After comparison and ranking, crude momentum systems just take trades from the top nth precentile and initiate a trade.
I am still in the process of getting used to RS systems and reading a lot.
Have to keep it short, currently vacationing in Austria!