Learn how to apply relative strength analysis, which compares an individual stock to the performance of a broad market index like the S&P 500.
Some traders who use technical analysis can fall prey to the idea that the more complex an indicator is or the more indicators you have on a chart, the better your analysis. With so many indicators to choose from, it’s easy to succumb to that thinking. The downside of complexity and using too many indicators? The indicators no longer retain their logic and can lose some effectiveness.
When it comes to identifying opportunities in the stock market, sometimes the simplest solution can be effective. So let’s take a look at using the relative strength (RS) indicator (not to be confused with Relative Strength Index, which is a momentum oscillator) to help find potentially profitable stocks.
One of the reasons relative strength is often overlooked is that it seems too simple. Its name is literal, it doesn’t involve any intricate mathematical theory, and it’s not named after a technical analyst.
Strength, relative to something else such as an index like the S&P 500 Index (SPX), generally indicates that a stock may perform better (or worse) over a given period of time.
If you think about it, it makes perfect sense. The stock market is in a constant state of ebbing and flowing. That ebb and flow can be within bull markets or bear markets.
Let’s take a look at some examples of relative strength to illustrate.
Figure 1 shows the performance of a technology stock compared to the Nasdaq Composite Index (NDX). Relative strength is charted in the subchart; the blue line represents the stock compared to the NDX.
When the RS (blue line) is moving up, it indicates that the stock is performing relatively better than the index it’s being compared against. When RS is moving lower, it indicates the stock is weaker than the index. The steepness of the RS line is also something to consider. A steeper RS line indicates how much better or worse the stock is performing. From the chart you see that the stock was consistently stronger than the index from April to July. During August, the RS line was steeper until it peaked and started declining in early September.
The RS can also be helpful in identifying divergences. When a market is falling, everything can look bad. Small caps, large caps, momentum stocks, value stocks—the whole lot. But the key to applying relative strength is to look for stocks that are falling less on a percentage basis than the market as a whole. For example, if the market is down 12%, but a stock is down 7%, it means the stock’s performing better relative to the overall market.
In the chart in figure 2, you can see that the stock declined (yellow line) most of February, but the RS was trending higher (purple line). This indicates the stock was doing better than the broader Technology sector.
These two examples show two different ways to use the RS indicator. One is to identify a potential trend and the other is to identify bullish or bearish divergences. But in both cases, the RS indicates whether the stock is outperforming or underperforming what it’s being compared to, which in this case is the Nasdaq Composite. But remember, you’re not limited to comparing a stock against an index. You can compare it to sectors, another stock, another index, or anything else.
Another way some use the RS is to confirm breakouts. Say a stock has been trading in a trading range for a while and is starting to show signs of a breakout on high volume. If the RS line trends upward prior to the breakout, it can act as a confirmation for the potential breakout.
Fund managers often compare their performance to a benchmark such as an index. You can use relative strength in the same way—to compare your portfolio holdings against a benchmark. This gives you the opportunity to identify which portfolio holdings are underperforming relative to your overall portfolio.
All of these examples looked at longer-term trends, but relative strength can be used for shorter time frames, too. It’s a simple and straightforward indicator, but it can be a powerful one for both investors and traders. Of course, as with everything in the market, there are no guarantees—only edges you can play based on probability. So, before you buy or sell a stock, see how it’s doing, relatively speaking.