About a month ago, I gave readers of this newsletter a little background on how our Maximum Profit system came to be.
For some of you, this was a reintroduction. For others, it may have been your first time hearing about the most successful investing systems this company has ever produced.
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In that issue, I mentioned that this system uses two of the most reliable indicators in the market -- one fundamental, one technical.
Today, I'd like to dive a little deeper into Maximum Profit's technical indicator, because I think it touches on one of the most important concepts too few investors know about or use themselves.
I'm talking about momentum.
More precisely, I'm talking about relative strength, which is one of the pillars upon which the Maximum Profit system is founded.
Relative Strength 101
To understand relative strength we first need to look at momentum investing.
In its most basic form, momentum investing is simply buying stocks when they go up and selling when they start to go down. But as easy as this sounds, historically many momentum investors have struggled with exactly when to sell.
They either hold on for too long and watch their gains return to zero, or they cut their winning positions too early, causing them to miss out on even bigger gains.
Another problem early momentum investors faced was not having a clear idea of what to buy next, which would lead to simply chasing the latest hot stock tip (in other words buying high and selling low.)
Relative strength (RS) allows us to incorporate momentum investing into a complete investment strategy. With RS we can set clearly defined buy and sell signals. Take the emotion out of the investment process, which has proven to be the bane of most investors' existence.
RS can be explained with a sports analogy. In any game, the winner plays in a way that is relatively stronger than the loser. If you were trying to select the winner before the game started, you would probably pick the team you thought was the stronger of the two. That might be the team with more wins or the team that enjoys an edge in some way for the upcoming game.
Investing is like a sports game in that there are winners and there are losers. RS is a tool that quantifies which stock is stronger (has the most wins this season) and is, therefore, more likely to keep winning. But it actually gives you an even bigger advantage.
Because most stocks have a fairly extensive trading history, selecting a winner is actually like picking a team after the game is already in progress. Researchers have found the team that is ahead after three innings in a baseball game wins about 80% of the time. In hockey, the team ahead after the first period wins nearly 70% of the time. In college basketball, if a team is leading by at least eight points at halftime, they win 80% of the time. In each case, the team that has the stronger start is likely to win in the end.
Just like in sports, we want to pick the stock that has been winning in the past because it has a better chance of winning in the future. RS allows us to quantify who the leaders are right now. And studies confirm that those stocks tend to outperform the average stock in the future.
In the Maximum Profit system, we specifically look for stocks with RS above 70 (this number is what we refer to as one of our stock market Tells). This means that they have outperformed 70% of all other investments during the past six months. This ensures we're holding only the best-performing stocks.
Relative strength is one of the few true edges available in the market.
Academics -- finance and economics professors -- explain the behavior of the markets with the Efficient Market Hypothesis (EMH). They believe markets efficiently price stocks using all available information. The strictest form of the hypothesis says that no individual can beat the market because each stock is trading at exactly the right price at all times.
Despite the theory, academics noticed that some investors do beat the market. After further review, they found that there are some exceptions to EMH. They named the exceptions "anomalies." Among the anomalies are value and momentum.
Researchers have proven that investors buying stocks with low valuations, such as low price-to-earnings (P/E) ratios, are more likely to beat the market than those buying stocks with high P/E ratios. They also found that buying stocks with high momentum (high RS) beats buying stocks with low momentum.
Only if a stock aces this test does it then move to the second part of my analysis.
We've all seen that shares will rise for reasons that have nothing to do with the performance of a company. Sometimes even unprofitable companies will see big gains in their share prices. They can rise on pure speculation, short covering or because of rumors. But we don't want to be buying the next Lehman Brothers... so that's where the second indicator comes into play.
Unfortunately, we'll have to save our second indicator for another day. But just know that if you're willing to change your mindset and embrace momentum stocks (by using RS), you can make a lot of money.
That's why the Maximum Profit system has racked up gains of 39%... 46%... even 181% -- all in less than 13 months. In fact, readers of Maximum Profit are sitting on two triple-digit gains and a plethora of double-digit gains right now. With a little discipline -- and by following the system's simple buy and sell signals -- you could be too. If you'd like to learn more, simply follow this link.
This article originally appeared on StreetAuthority.