Using Relative Strength in Trading: A Key Tool for Market Outperformance

Relative strength (RS) is a powerful tool in the arsenal of traders and investors looking to outperform the market. By comparing the performance of a specific asset to the overall market or a benchmark index, traders can identify securities that are showing superior performance, thus providing potential trading opportunities. This article delves into what relative strength is, how it is calculated, and how it can be effectively used in trading.

Understanding Relative Strength

Relative strength is a measure that compares the performance of a stock or other financial instrument against a benchmark, usually an index such as the S&P 500. The goal is to identify securities that are outperforming or underperforming the benchmark over a specific period. Unlike the relative strength index (RSI), which is a momentum oscillator, relative strength in this context is used to identify trends and strength relative to the market.

Calculating Relative Strength

The calculation of relative strength is straightforward:

$\text{Relative Strength} = \frac{\text{Price of the Security}}{\text{Price of the Benchmark}}$

This ratio is then plotted over time to create a relative strength line or chart. A rising relative strength line indicates that the security is outperforming the benchmark, while a falling line suggests underperformance.

Using Relative Strength in Trading

1. Identifying Strong Performers: One of the primary uses of relative strength is to identify securities that are strong performers relative to the market. According to research by Investors Business Daily, stocks with strong relative strength often continue to outperform . By focusing on these securities, traders can potentially enhance their returns.

2. Trend Confirmation: Relative strength can also be used to confirm trends. If a stock is in an uptrend and its relative strength line is also rising, this is a positive confirmation that the stock's performance is robust relative to the market. Conversely, if a stock is rising but its relative strength line is falling, this could be a warning sign of potential weakness.

3. Screening and Filtering: Traders can use relative strength to screen and filter stocks. For instance, they can set criteria to only trade stocks that have a relative strength line above a certain level. This helps in narrowing down the selection to those securities that are exhibiting strong relative performance.

4. Diversification: Relative strength can be used to diversify a portfolio. By selecting stocks from different sectors that have strong relative strength, traders can spread their risk while still focusing on high-performing assets. This strategy is supported by studies indicating that diversification can reduce risk without sacrificing returns .

5. Market Rotation: The concept of market rotation involves moving investments from one sector to another based on relative strength. For example, during a period when technology stocks are showing strong relative performance, a trader might overweight their portfolio in tech stocks. When another sector, such as healthcare, begins to show superior relative strength, the trader can rotate their investments accordingly.

Examples of Relative Strength in Action

1. CAN SLIM Methodology: Developed by William O'Neil, the CAN SLIM investing strategy heavily relies on relative strength. O'Neil's approach involves selecting stocks with high relative strength ratings, among other criteria, to identify potential winners in the market .

2. Sector Rotation: During different phases of the economic cycle, certain sectors tend to outperform others. By using relative strength analysis, traders can identify which sectors are leading the market and adjust their portfolios accordingly. This method is commonly used in sector rotation strategies to capitalize on shifting market dynamics .

3. Momentum Investing: Momentum investors look for stocks that have shown strong performance over a recent period, expecting that this momentum will continue. Relative strength is a key indicator for identifying such stocks. Studies have shown that momentum strategies, which often utilize relative strength, can generate significant returns over time .

Conclusion

Relative strength is a versatile and valuable tool for traders and investors aiming to outperform the market. By identifying strong performers, confirming trends, and aiding in diversification and market rotation, relative strength can significantly enhance trading strategies. Whether you are a short-term trader or a long-term investor, incorporating relative strength analysis into your decision-making process can provide a competitive edge in the financial markets.