What Traders Should Know about Relative Strength - dummies

What Traders Should Know about Relative Strength

By Michael Griffis, Lita Epstein

Relative strength can help you when making trading decisions. Relative strength measures the performance of one stock against another or, more commonly, against the performance of an index such as the S&P 500. The idea is to determine how the stock is performing compared with the broad market.

Unfortunately, you may run across another indicator with a similar name when working with your charting software. The other indicator is called the relative strength index (RSI), and it is something completely different from the relative strength discussed here. RSI is an oscillator that is used in a way similar to the stochastic oscillator.

How to calculate relative strength

Among the many ways that you calculate relative strength is simply dividing the stock price by the index value and plotting the result, like this:

Relative strength No. 1 = stock price ÷index value

Another technique compares the price of the stock during a given period of time against the index during the same period. Our preference is comparing percentage changes during the same period. The calculation looks like this:

Relative strength No. 2 = percentage change in stock price ÷percentage change in index value

Either of these approaches, or any other that you may invent, can be plotted on a stock chart. Some Internet sites provide a relative strength capability. Unfortunately, if you’re using a charting software package, you’ll probably have to program it into your system by using its formula-editing capabilities.

Investor’s Business Daily has a proprietary calculation for relative strength that ranks stocks based on their six-month performance. It’s a handy tool.

StockCharts.com lets you create your own performance chart using whatever indexes and stocks you want. You can choose up to ten symbols. Go to Stockcharts.com and click on any of the performance charts that interest you, such as major U.S. Market Averages or S&P Sector ETFs. You can then edit the stock symbols at the bottom of the chart.

Put relative strength to work

The goal when examining a stock’s relative strength is not necessarily to find the best-performing stocks in the universe of all stocks but rather to find stocks that are performing better than the average stock as each stock signals a buy.

Relative strength is one of the final pieces of the technical-analysis puzzle. You’ve found a trading candidate when you find a stock that

  • Exhibits fundamentals as a strong company

  • Has earnings that are growing faster than average

  • Functions well in a strong sector

  • Operates in a growing economy

  • Is approaching a technical buy signal on its bar chart

  • Performs better than the average stock

These characteristics favor a long position, of course. For short position candidates, reverse each criterion.