There are thousands of stocks in the market, and dozens — if not hundreds — of industries. You can study them everyday in search of trades, and still miss plenty. That’s why many traders use relative strength to focus on potential opportunities.
Relative Strength Uses a Benchmark
Relative strength measures the performance of a stock or index against a broader benchmark like the S&P 500. It compares simple percentage changes over given time periods. If the security is up 10 percent in the last week while the index is up 2 percent, it would have positive relative strength. And vice versa to the downside.
This is especially useful because it compensates for movements in the broader stock market. Relative strength lets you know when a company has more buying pressure than selling pressure. You can see which names are truly under accumulation, rather simply following others higher.
Relative Strength Spots Market Trends
Knowing the difference is important because those investors who believe in a company generally stick around for a while. They’ll buy for months, quarters or even years. They’re often longer-term investors who can provide a solid backstop of demand. Relative strength is one of the simplest tools to find them.
Remember, trends usually start with large amounts of institutional money flowing into or out of the market. That includes pension funds and wealthy individuals. Some could be insiders with deep knowledge of a business.
As Charles Dow first described in the late 1800s, the “public participation” phase comes next. Savvy individuals notice the price action and start following the trend. Relative strength is can be especially powerful by finding companies at this stage, as their demand base widens.
Pullbacks and Relative Strength
While relative strength can be useful in any market environment, it can really shine when the broader market pulls back. If the S&P 500 is crashing, most companies will follow it lower. But a handful of stocks may hold their ground or barely drop.
These are often the same companies that were rallying before the volatility struck. Very often, they will outperform the broader market once the correction is over. Relative strength can focus our attention on those names.
There’s another way to use the same concept with moving averages. Say the broader index plunges under its 200-day moving average, but some stocks are holding their 50-day moving averages. Their shallower declines would be another example of relative strength.
Anyone who’s looking at the stock market will quickly realize there are tons of indicators and ways of choosing investments. Some people look at earnings multiples, discounted cash flow or quantitative metrics.
While these all have some value, they can overwhelm individual traders. Relative strength can cure this “paralysis by analysis” because it’s simple and effective.
After all, investors may love or hate a stock for any reason. We just care about it going up or down. Trying to understand the “why” can be a waste of time. Why not simply focus on the “what?” Relative strength provides that insight.
Relative Strength Isn’t the Same as RSI
Finally, readers should be aware that the relative strength indicator is different from the Relative Strength Index (RSI). The relative strength indicator is a simple comparison of percent price change against an index. RSI, on the other hand, considers points gained on bars with higher closes and the points lost on lower closes.