Chapter 7-1 Relative Strength

Trading is one of the most fascinating, challenging, and rewarding businesses on earth.  While trading we often look for price patterns that have a high probability of follow through.  We then evaluate market internals to see if it makes sense to enter a bullish or bearish trade.  If acceptable, we then calculate share size per our trading plan, enter the trade, and proceed to management mode.  When looking for stocks to trade in a particular sector, it is best to trade the “cleanest” patterns which are those displaying relative strength for longs and relative weakness for shorts.

There is often confusion when discussing Relative Strength (RS) and Relative Strength Index (RSI).  Many are under the false assumption that these two are the same; in reality they are as different as the North and South Pole.

Suppose you want to pick some stocks, how are you going to go about doing so?  What will be your method?  At Equity Scholar we suggest the use of the top-down approach.  First, find the sectors which are outperforming the S&P Futures.  Next, find the strongest stocks within these sectors.  Then, use Relative Strength to determine the strength of a stock.  To do this, take the percent gains of a stock and divided that by the percent gains of the benchmark index (we suggest using the SPY or S&P Futures).  If this ratio is rising, then the stock is outperforming the index.

What Does Relative Strength Mean?

Relative Strength is a measure of price trend that indicates how a stock is performing relative to other stocks in its industry (or the overall market (SPY)).  It is different than the Relative Strength Index (RSI), a popular technical indicator.

How is Short Term Relative Strength Calculated?

Relative Strength is calculated dividing the price performance of a stock by the price performance of an appropriate index for the same time period.

RS 1 (SPY) = (Current price-LOW) / (HIGH-LOW)

RS 2 (Stock) = (Current price-LOW) / (HIGH-LOW)

RS = RS 1 / RS 2

We use RS to value the strength or weakness of a stock.  An example is when a stock is on its high and the SPYs or S&P Futures are on their low.  This divergence indicates that the stock is behaving opposite of market forces, and exhibits a very motivated buyer.  To trade set ups like this we must look for stocks that are trading opposite of the market that show an exceptional strength or weakness.  This indicator should be coupled with AVOL to determine if there is potential for a legitimate move.

AVOL Ratio

Average volume (AVOL) ratios are calculated by taking the current volume today and dividing it by the historical volume (1 Month and 20M = 20 minutes) over the same time period.

For example, if the total market volume today from 9:30 – 10:30 am (with 10:30 am being the current time) is 10,000,000 and the 1 Month average historical volume from 9:30 – 10:30 am is 8,000,000, then the AVOL ratio is 10,000,000/8,000,000 = 1.25.  Volume ratios > 1 show increased volume relative to the average, where as values < 1 show decreased volume.  The 20M volume ratio provides a more localized indication of volume.

Relative strength is very useful in today’s market place as we have seen increasing divergences within sectors.  Many of us at Equity Scholar focus heavily on this strategy, as we find this improves overall consistency within our trading universe.  When using Relative Strength you must remember to watch the SPY and/or the S&P Futures intently to see how your overall position reacts when the market moves against your overall net position.  When the S&P Futures fall and you are net long, you should look to add to your positive trades as you see support come into the market place.  To reiterate- if a stock maintains strength and does not drop when the market does it is a bullish sign.  If and when the market reverses and begins to ascend, even slightly, your long positions should be handsomely rewarded.  It is important never add to a losing trade.  Just like with all types of trading strategies and styles, discipline is the key to success.

S&P Futures

To properly implement this strategy it is essential to identify stocks with relative strength in the upper and lower 25% ranges.  By comparing the actions of the overall market with a stock, we can identify if any relative strength or weakness exists.  Analyzing how a stock reacts during significant moves in the S& P Futures provides insight on the strength or weakness in a stock.

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Longing a RS Stock

  • We are seeking stocks that are trading within 25% of the high end of the range.
  • We are also looking for stocks that are trading at least 1.5 times their average trading volume for that time period.

 

Although this trade can be put on at most times of the trading day, it is generally recommended that a trade be initiated after 9:40 a.m., once the trend has been established.  Also, make sure the market does not continue its downtrend as we would like to buy these stocks as the market turns in our favor.

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Shorting a RS Stock

  • We are seeking stocks that are trading within 25% of the low end of the range.
  • We are also looking for stocks that are trading at least 1.5 times their average trading volume for that time period.

Although this trade can be put on at most times of the trading day, it is generally recommended that a trade be initiated after 9:40 a.m., once the trend has been established.  Also, make sure the market does not continue its uptrend as we would like to be short these stocks as the market turns in our favor.

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Relative Strength Investing:  What to Do in a Rough Market?

The bottom line is that people are much more inclined to buy stocks than they are to short them.  If you are one of these individuals, what do you do when the environment for equities is as rough as it’s been lately?

One thing you could do is cut back on your holdings and wait for a more favorable climate before putting more of your cash to work.  However, what if you want to be fully invested?  That’s a little trickier.  We are a big believer in following the trend.  And let’s face it — the trend has not been up lately.  Market experts estimate that approximately 75% of stocks move in the same general direction as the overall market.  So, in times like these, you are fighting an uphill battle by staying fully invested.

What if you want to find out where the most advantageous place is to invest right now? Not every single stock follows the overall market.  After all, if 75% of equities are going down, that still leaves 25% going up right? Where is one likely to find them?

Relative Strength Investing:  Not Investing Based on Absolutes

We look to employ our concept of “Relative Strength” to locate some of these contrary gems.  Relative Strength, to reiterate, is a term used by practitioners of technical analysis to evaluate how a stock or a group of stocks are performing in comparison to either another group of stocks or the broad market as a whole.  In other words, a stock’s Relative Strength measures how it is performing on a relative, as opposed to on an absolute, basis.

We put the concept of Relative Strength into action by comparing the overall performance of several different stock market sectors.  In order to conduct a proper examination, we look at the performance of the nine Select Sector SPDRs that are actively traded on the American Stock Exchange (AMEX).

These SPDRs are exchange-traded funds (ETFs) that consist of separate baskets of stocks selected from each of nine general segments of the market.  We chose to use the Select Sector SPDRs because; taken together, these nine ETFs represent a broad cross-section of the equities market.  Furthermore, each one fairly reflects the price performance of the stocks in their particular market segment.  Here are the nine Select Sector SPDRs we use:

Consumer Discretionary Select Sector SPDR (AMEX:XLY)

Consumer Staples Select Sector SPDR (AMEX:XLP)

Energy Select Sector SPDR (AMEX:XLE)

Financial Select Sector SPDR (AMEX:XLF)

Health Care Select Sector SPDR (AMEX:XLV)

Industrials Select Sector SPDR (AMEX:XLI)

Materials Select Sector SPDR (AMEX:XLB)

Technology Select Sector SPDR (AMEX:XLK)

Utilities Select Sector SPDR (AMEX:XLU)

Relative Strength Investing:  The Best Places to Invest, According to Relative Strength

Now, let’s rank each of these nine Sector Select SPDRs by their percentage return over at least a 1 month period.  This will show us the Relative Strength of each of these nine broad market sectors.  With this information we’ll be able to assess what has been working in this challenging market environment.

Here are the percentage returns through the close of trading on an arbitrary trading day:

Utilities Select Sector SPDR (AMEX:XLU)                               +6.7%

Health Care Select Sector SPDR (AMEX:XLV)                         +3.3%

Consumer Staples Select Sector SPDR (AMEX:XLP)                +1.5%

Financial Select Sector SPDR (AMEX:XLF)                              -4.0%

Energy Select Sector SPDR (AMEX:XLE)                                 -4.8%

Consumer Discretionary Select Sector SPDR (AMEX:XLY)     -7.9%

Industrials Select Sector SPDR (AMEX:XLI)                           -9.6%

Technology Select Sector SPDR (AMEX:XLK)                         -11.8%

Materials Select Sector SPDR (AMEX:XLB)                             -12.9%

As you can see in this example of the market, the best places have been utilities, health care, and consumer staples issues.  Now, as conditions change we could well see other sectors assume leadership roles, but right now those top three sectors listed above would be a good place to hunt for potential winners in the short term.  Moreover, when considering whether or not to adjust your portfolio evaluate if you are invested in top performing groups.

By employing our concept of Relative Strength you are able to hone in on the best performing areas of the equities world.  At the same time, by measuring the Relative Strength of different market sectors you are able to discern which areas to trim back on and which areas to avoid altogether.  This helps immensely as there are way too many stocks to follow tick by tick.  Thus, when trying to decide where to invest some cash consider using Relative Strength to aid your decision making process.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a financial technical analysis momentum oscillator measuring the velocity and magnitude of directional price movement by comparing upward and downward close-to-close movements.  Momentum measures the rate of the rise or fall in stock price.  Is the momentum increasing in the “up” direction or is the momentum increasing in the “down” direction?  A simple way to picture momentum:  Imagine a ball rolling down a hill.  It starts off pretty slow and then as it gets further down the hill it picks up momentum and starts rolling faster.

The RSI was developed by J.  Welles Wilder and first published in Commodities in June 1978 and in his New Concepts in Technical Trading Systems the same year.  The process of determining RSI is as follows:

For each day an upward change (U) or downward change (D) is calculated.  “Up” days are characterized by the daily close being higher than yesterday’s daily close, i.e.:

U = closetoday − closeyesterday

D = 0

Conversely, a down day is characterized by the close being lower than the previous day’s (note that D is nonetheless a positive number),

U = 0

D = closeyesterday − closetoday

 

If today’s close is the same as yesterdays, both U and D are zero.  An average for U is calculated with an exponential moving average using a given N-days smoothing factor, and likewise for D.  The ratio of those averages is the Relative Strength,

RS = EMA [N] of U

          EMA [N] of D                                          

This is converted to a Relative Strength Index between 0 and 100,

RSI = 100 – 100 x      1   _

                                1 + RS

 

Note that the term Relative Strength also refers to the strength of a security in relation to its sector or the overall market.  For instance, ABC might rise 2% when S&P 500 rises 1%.  This is sometimes called Comparative Relative Strength to avoid confusion.  It’s unrelated to the Relative Strength Index described here.

Wilder posited that when price moves up very rapidly at some point it is considered overbought.  Likewise, when price falls very rapidly at some point it is considered oversold.  In either case, Wilder felt a reaction or reversal is imminent.  The slope of the RSI is directly proportional to the velocity of the move.  The distance traveled by the RSI is proportional to the magnitude of the move.

As a result, Wilder believed that tops and bottoms are indicated when RSI goes above 70 or drops below 30.  Traditionally, RSI readings greater than the 70 level are considered to be in overbought territory, and RSI readings lower than the 30 level are considered are to be in oversold territory.  In between the 30 and 70 level is considered neutral.  Wilder further believed that divergence between RSI and price action is a very strong indication that a market turning point is imminent.  Bearish divergence occurs when price makes a new high but the RSI makes a lower high, thus failing to confirm.  Bullish divergence occurs when price makes a new low but RSI makes a higher low.

Wilder thought that “failure swings” above 70 and below 30 on the RSI are strong indications of market reversals.  For example, assume the RSI hits 76, pulls back to 72, and then rises to 77.  If it falls below 72, Wilder would consider this a “failure swing” above 70.

Finally, Wilder wrote that chart formations and areas of support and resistance could sometimes be more easily seen on the RSI chart as opposed to the price chart.  The center line for the Relative Strength Index is 50, which is often seen as both the support and resistance line for the indicator.

If the Relative Strength Index is below 50, it generally means that the stock’s losses are greater than the gains.  When the Relative Strength Index is above 50, it generally means that the gains are greater than the losses.  So these technical indicators help you link the dots of the big picture.  When trading capital markets there are no absolutes, just opinions.  For every trade there is a buyer, with one opinion, and a seller, with another.

Why should you care about how the stock is performing relative to the market?  In some cases, it provides little, if any, use.  A value stock that you are hoping to pick up for a quick profit won’t show up on a screen for strong relative strength.  Of course, you can screen for low relative strength also.  However, if you are looking for a stock that is making a move upward consider using Relative Strength to measure whether the move is a recent blip or a sustained rise in value.  Stocks that have shown good relative strength over a reasonable period have some market validation.  If other investors didn’t like the stock, its price wouldn’t continue to rise.  There’s nothing wrong with buying a stock on the way up.  Relative Strength is one way to confirm that a move has true lasting power.

Conclusion

Now that you are familiar with both Relative Strength and the Relative Strength Index, you should be able to discern the difference between these two instruments of trading and investing.  Relative Strength indicates that if a stock is trading opposite of the market it resides in with greater than average volume then a continuation of the move is expected.  While the Relative Strength Index indicates when a stock is too far from its common range and is expected to snap back.

As always, Relative Strength is only one of many factors you should consider before trading or investing.  However, it does give you a strong signal about how the stock is performing.  A trader’s job is to trade prices, and there are fundamental, quantitative, economic, and technical indications of whether a price is low or high.  Furthermore, RSI is a valuable technical indicator, but like with all indicators, it has greater accuracy when used in combination with other indicators and analysis.

Questions