Trading with Relative Strength

Do you know that relative strength can help us in trading in stronger stocks? Yes! You heard it right. Relative Strength is a momentum strategy that helps us in identifying strong stocks for trading as compared to the Index. With the help of Relative Strength, traders will look for those companies which have outperformed their peers or the index either by rising more or falling less as compared to the peers or index.

Relative strength helps us in predicting that the trends currently displayed by the stocks will continue for long enough and we can realize a positive return. However, traders should note it is different from the Relative Strength Index.

So, without further delay let us understand what is meant by Relative Strength and how we can trade with it:

What is Relative Strength (RS)?

Relative Strength refers to the measurement of the stock’s performance as compared to its benchmark or another stock. RS compares the performance of stock “X” vs “Y”, measured over a period. For example, “X” may increase more or less than “Y” in a rising market or “X” may fall more or less as compared to “Y” in a falling market. It is one of the tools for momentum investing.

This measure helps us in identifying both the strongest and the weakest securities or any asset classes within the financial market. Usually, the stocks which display strong or weak RS over a given time period tend to continue going forward. One should note that RS analysis can be applied to any domestic or international stocks, stock indexes, fixed income indexes, currencies, commodities, and any other asset classes.

You must have heard about beta and alpha when studying statistics in school? If not, let us recap these concepts in this context. Don’t worry we won’t be too statistical!

Beta and Alpha? Why are we talking about them here?

Beta is a measure of volatility relative to a benchmark, and it’s actually easier to talk about beta first. It helps us in measuring the systematic risk of a security or a portfolio compared to an index like the Nifty 50.

Whereas the Alpha is the excess return on an investment or a stock after adjusting for market-related volatility and random fluctuations. Alpha is one of the major risk management indicators when it comes to analyzing mutual funds, stocks, and bonds. In a sense, it tells investors whether an asset has consistently performed better or worse than its beta predicts. So alpha more than 0 means that a stock has outperformed and less than 0 means that a stock has underperformed after adjusting for volatility.

One should note that the high beta stocks would be more profitable but are also riskier. The high beta stocks could also have a negative alpha which means that although more volatile their trends compared to the Nifty50 could be downward. So when alpha is compared among the stocks it provides us with a relative strength measure and stock lists can be ranked by alpha to show which stocks are the strongest.

Calculation of Relation Strength

Now let us come to the calculation of RS. RS is calculated by using the below formula for comparing a stock’s price change to a change in index prices. 

RS= Stock’s Price / Index’s Price

For calculating the RS of one stock to the another where N is the first stock and N2 is the stock we are comparing it to is as below:

RS= N Stock’s Price/ N2 Stock’s Price

One should note that the period of both the assets should be the same such as one day or one year.

Difference between Relative Strength and Relative Strength Index

As we said at the beginning that RS is different from RSI. Relative Strength Index (RSI) is a momentum indicator that measures the magnitude of recent price changes for evaluating overbought or oversold conditions in the price of a stock or other asset. 

The main difference between relative strength and RSI is a difference of perspective. The relative strength tells us about the value of a stock in comparison to another stock, index or sector, whereas the RSI tells about the performance of a stock in comparison to the recent performance of the same stock.