How to Use Sector Strength to Find Stocks Before They Move
I have a weekly webinar on Mondays to review the markets and one thing we do is look at sector strength. Those who are in the 5K Challenge can attend this session for free. You can reach out to [email protected] for more information.
One of the items we discuss each week is looking for S&P 500 sectors and looking for ones that are overbought, oversold, and ripe for a move higher.
In this article I’m going to go over one way you can use sector strength.
The goal of this strategy is simple: find stocks that are in long-term uptrends but currently pulling back in the short term. I do this by following a structured approach:
- Identify S&P 500 Sectors with 70% or More of Their Stocks Above the 20-Day Moving Average
- This tells us which sectors have broad short-term strength. When a large portion of stocks within a sector are trading above their 20-day moving average, it signals momentum. But we don’t want to chase stocks that have already run too far.
Based on the graphic above, the S&P 500 Consumer Discretionary, Consumer Staples, Financials, Health Care, Materials, Real Estate, Communication Services, and Utilities all fit the criteria of strong sectors that I want to move on to the next step.
There are over 300 stocks that fit that criteria and some of them have already had their move higher, so we need to filter this list more.
- Filter for Stocks Above Their 200-Day Moving Average but Below Their 20-Day Moving Average
- This is the key to finding high-probability setups. If a stock is above its 200-day moving average, it’s still in a long-term uptrend. But if it’s below its 20-day moving average, it means the stock has pulled back—potentially offering a strong risk-reward entry point.
- Prioritize Stocks That Are Near Their 200-Day Moving Average
- We want stocks that are not just slightly below their 20-day but significantly below it. The best setups often come when a stock is hovering near its 200-day moving average, using it as a launchpad for the next move higher.
Here’s the list after that filter – a much more reasonable amount to review:
We are in the middle of earnings season, so you may want to apply an additional filter to stay away from earnings announcements in the next couple of weeks.
Why This Works
This approach blends momentum and mean reversion, capitalizing on stocks that are already in an uptrend but have temporarily fallen out of favor. The 200-day moving average acts as a psychological level—many traders and institutions use it to gauge long-term trends. When a stock pulls back to this level in a strong sector, it often attracts buyers looking to ride the next leg higher.
How to Execute This Strategy
- Set Alerts: Use trading platforms to set alerts for stocks crossing below their 20-day moving average but remaining above their 200-day.
- Check Volume: Look for increasing volume on a stock’s approach to its 200-day moving average—this suggests institutional buyers may be stepping in.
- Confirm Sector Strength: Ensure the sector remains above 70% on the 20-day moving average scan before entering a trade.
- Use Stop Losses: A close below the 200-day moving average could invalidate the setup. Place stop-losses accordingly.
I like using credit spreads with this strategy and placing a sold put right under the 200-day moving average (assuming my risk-to-reward ratio is acceptable). I place the short put there because I don’t want to be involved in a stock trading under its 200-day moving average anyway.
There are a few important things to note here – with any scan I highly suggest you review the chart (or your favorite entry signal). Don’t arbitrarily take a trade just because it hits your scanner. I’ll show you some examples in a moment. The other thing to note is sometimes you won’t be able to get close to the 200-day moving average.
Let’s look at Booking (BKNG). It’s in an uptrend but has pulled back quite a bit since December. It’s trading at $4774 and the 200-day moving average is $4200.
Going out to the 21 FEB expiration and setting up a bull put spread under the 200-day moving average would mean something like this SELL VERTICAL BKNG 100 21 FEB 25 4200/4100 PUT @6.30 LMT MARK.
You’re risking $9370 to potentially make $630; a risk-to-reward ratio of 15:1. I’m not touching that with a 10-foot pole. They also have earnings coming up soon, but still.
Here’s another one that unfortunately has earnings, but if you can forgive that part, look at this chart for Expedia. The 200-day moving average is just below $150, and while that’s too low to sell a put, it looks like it’s forming a bottom and trying to turn around near the $170 level. What if we look at selling a put spread around the $160 level.
This option is inflated due to earnings, but you could SELL -1 VERTICAL EXPE 100 21 FEB 25 160/155 PUT @1.51 LMT MARK. That’s giving a much more favorable 2.31 risk-to-reward ratio.
That’s putting a spread below a support area on a stock that experienced a pullback, while the rest of the sector is rising – remember that more than 70% of stocks in the sector are above their 20-day moving average.
You can always sprinkle in some seasonality for good measure. Since 2010, EXPE averages a 1.02% gain in February trading higher in 8 of the last 15 years.
There are so many ways you can refine this strategy, but I like looking for stocks within strong sectors. You can add a filter of looking for stocks outperforming the S&P 500 performance over the last 1 month or even 1 year to make sure you are trading good stocks.
Final Thoughts
While most traders react to headlines, this strategy is about staying ahead of the curve. By tracking sector strength and identifying the right stocks within those groups, you can position yourself for high-probability setups before the next move unfolds. The key is patience—waiting for the right mix of technical conditions before pulling the trigger.
That’s it for me this week. I hope each of you enjoyed the first month of 2025!
