In my book, Trading ETFs: Gaining an Edge With Technical Analysis, I explain that one key step of my top-down strategy of ETF trading is to determine which industry sector indices are showing the most relative strength or weakness to the broad market. By doing so, one can subsequently compare the performance of individual ETF families within that sector in order to determine which ETF is showing the most relative strength or weakness to the sector index.
To spot relative strength or weakness, I suggest setting up a workspace on your trading software that uses numerous percentage change charts, comparing the price action of various industry sector indices to the price pattern of the S&P 500. Recently, a few subscribers have asked me to show an actual screenshot of this, and I'm happy to do so. Check out the graphic below (excuse the larger-than-usual size, but it was necessary in order to see the image clearly).
Relative Strength and Weakness - 25 Sector Indices vs. the S&P 500
Source: TradeStation
What you're looking at is 25 different charts, each comparing the percentage change of the S&P 500 (the black lines) with a specific industry sector index (the blue lines). Each chart is set to display the most recent 10 days of data. Though the data is updated in real time, it could just as well be updated on an end-of-day basis. The basic idea here is to determine quickly which areas of the stock market are seeing sector rotation at any given time. The sector indices outperforming the gains of the S&P 500 usually have relative strength, while those underperforming could be said to have relative weakness. From this information, one could easily know which sectors may present the best buying and/or short-selling opportunities. The next very important step, however, would be to look at the longer-term daily chart pattern of the index to make sure that the chart pattern does not overly conflict with what is being shown on the short-term overlay chart.
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At the time of publication, Wagner had no positions in the stocks mentioned.
Deron Wagner is the founder and head trader of Morpheus Trading Group. His daily focus is managing and trading the Morpheus Capital Hedge Fund, which he founded in April of 2004. He also teaches his trading methodology with The Wagner Daily, The MTG Stalk Sheet, and The Wagner Weekly newsletters.
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