You need to optimize the use of your business capital. This requires you to consider several factors before initiating a trade. This week we discuss the factor that should kick off 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. From those you pre-select, you can choose the underlying that has the best breakout. This could be a make or break candle: a green colored candle that has a decent sized body with a close at or near the high of the day. To further determine the relative strength of the underlying’s breakout, you can look at the strength of the bulls at the breakout point. One way to determine this is to observe how the bulls behaved on the path to the breakout price. The fewer consecutive green candles in the last leg before the breakout price, the better; as this indicates that the bulls are holding on to their capital to push the price higher after the breakout.

Alternatively, you can use the relative rotation chart^® (RRG). The RRG was created by Julius de Kempenaer to determine the trend and dynamics in various sectors. Kempenaer divided the graph into four quadrants: leading, weakening, lagging and improving. Note that the leader occupies the upper right quadrant and the laggard the lower left quadrant. Through extensive research and analysis, Kempenaer discovered that sectors continually rotate between these quadrants. You just need to understand that you want to initiate a long position in a sector that is moving in the leading quadrant. To do this, you need to observe the wavy line graphs that point upward and move in the main quadrant (moving northeast). Note that the sectors are referenced 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, we must move to the granular level: look at the stocks constituting the sector. The rules we discussed above for the sector also apply to individual stocks. You must therefore select a stock that evolves in the leader quadrant. You can then initiate a long term position on this security.

Relative Rotation Chart

One can also use the Relative Rotation Graph® to determine the trend and dynamics in various sectors.

Optional reading

The breakout candle decisive rule will allow you to initiate a trade in reaction to the breakout. The RRG will offer entry into a transaction at an early stage of momentum. Both have their associated risks. You may need to enter a breakout trade at a price well above the breakout level. This could expose your capital to high risk, as the stop-loss will likely be lower than the breakout price. There is also a possibility of a false breakout. Likewise, the RRG may take a sharp turn and move down into the weakened or lagging quadrant after you initiate a long position. You must trade with a strict stop-loss to manage losses, in case the trend changes.

The author offers training programs for individuals to manage their personal investments