Mastering derivatives: When relative strength matters

You must optimse the use of your trading capital.

This requires you to consider several factors before you initiate a trade.

This week, we discuss the factor that should kick-start your trading decision: which underlying to trade? Relative signals There are several ways to determine which underlying you should trade.

Suppose you decide to initiate a long position.

Of the ones you shortlist, you can choose the underlying that shows the best breakout.

This could be a decisive candle: a green colour candle that has a decent size body with a close at or near the day’s high.

To further determine the relative strength of the underlying’s breakout, you can observe how strong the bulls are at the breakout point.

One way to determine this is to look at how bulls fared on the way to the breakout price.

The lesser number of consecutive green candles on the last leg before the breakout price, the better; for this indicates that the bulls are conserving their capital to drive the price after the breakout.

Alternatively, you could use the Relative Rotation Graph® (RRG).

The RRG was created by Julius de Kempenaer to determine the trend and momentum in various sectors.

Kempenaer divided the graph into four quadrants: leading, weakening, lagging and improving.

Note that leading occupies top right quadrant and lagging, the bottom left quadrant.

Through extensive research and analysis, Kempenaer found that sectors rotate continually between these quadrants.

Suffice it to understand that you want to initiate a long position in a sector that is moving into the leading quadrant.

To do this, you should observe the squiggly line graphs that point upwards and move into the leading quadrant (moving Northeast).

Note that the sectors are benchmarked to the index to which they belong.

At this point, you have two choices.

You could take sector bets if futures are available on these indices.

Otherwise, you must switch to the granular level: look at constituent stocks in the sector.

The rules that we discussed above for the sector applies to individual stocks too.

So, you should select a stock that is moving into the leading quadrant.

You can then initiate a long futures position on this stock.

Optional Reading The decisive breakout candle rule will allow you to initiate a trade as a reaction to the break-out.

The RRG will offer entry into a trade at an early stage of the momentum.

Both have their associated risks.

You may have to enter a break-out trade at a price well above the break-out level.

This could expose your capital to high risk, as the stop-loss is likely to be below the break-out price.

Also, there is a possibility of a false breakout.

Likewise, the RRG may take a sharp turn and head downwards into the weakening or lagging quadrant after you initiate a long position.

You must trade with strict stop-loss to manage losses, in the event the trend changes.

The author offers training programmes for individuals to manage their personal investments.