Market conditions like the one we are seeing now often lead to confusion and errors. What if there was a way to simplify price movements so you can focus on what matters!
Remember , a stocks price consists of two components – a) A systematic risk , meaning market and sector led price movements and an b) unsystematic risk, which is specific to the stock itself.
However, while taking or removing positions, we often mix up the two and end up making costly mistakes. There is a school of analysis called the Relative Strength Analysis, which is a very powerful indicator that can capture potential outperformers even when the markets are trending down!
Introduction
Quite often, one hears the word “relative strength” on media channels– which is often conveyed as the price movement of a stock versus its index, or sector or market returns over various time periods. We often hear it, pat ourselves on our backs (or rue the missed opportunities) and move on. Almost all research reports carry these returns as well as a table on their cover page but we often don’t pay much attention to it.
Well, one should pay attention and one should do something about it as it is a very simple yet powerful tool in our hands!
What is RPS
Relative Price Strength (RPS), also known as relative strength, is the ratio between the price trend of a stock price compared to the price trend of the market. When its applied to stocks versus stocks, it broadly resembles how one would do pairs trading but that’s a different concept altogether. Similarly, RPS is not to be confused with relative price index which is a technical indicator.
Relative price strength (RPS), also known as relative strength, is the ratio between the price trend of a stock price compared to the price trend of the market. RPS is commonly used in technical analysis and is not to be confused with relative price index.
Relative strength analysis is simply dividing one market element by another. If this number is increasing, the one you divided it into is stronger; if this number is decreasing, the one you divided by is stronger. You can use this to compare a market sector to the economy in general, or you can pick a company and compare it to the sector’s performance.
In essence, it’s a stock that is showing strength relative to the market. Say the Nifty is down 1% on the day, yet Reliance is up 1%. That’s a stock showing relative strength – the ratio has gained 2% (1%+1%) .
On a one-day measure, relative strength isn’t all that convincing. But say the market is going through a really choppy period or is under a lot of selling pressure for a prolonged stretch. When a stock is standing tall during that period of time, then it’s really worth a closer look.
Don’t confuse a falling RS with a falling stock price. You can easily have a rising stock with a falling RS but it just means that the stock is climbing moderately less than its benchmark, lets say Nifty.
There are Four Scenarios When Using RS:
Price ↑ + RS ↓ = Stock climbs less than Nifty
Price ↑ + RS ↑ = Stock climbs more than Nifty
Price ↓ + RS ↑ = Stock drops less than Nifty
Price ↓ + RS ↓ = Stock drops more than Nifty
These calculations therefore present a great view of the “relative” momentum of the stock versus the market.
Relative strength plays are often a good place to “hang out” during market turbulence, but they usually outperform when the market comes back to life as well. Of course life is not as simple as this but with the RPS, you have a much higher probability of success.
Illustration
The charts below are both representations of the same stock – Reliance Industries – over the last 1 year.
The first chart is the actual price movement of the stock while the second one is its relative movement versus the Nifty.
See the right hand side of the second chart and you will realise how the charts help – Reliance collapsed as the market did but on the relative price chart, it made a bottom much faster – and the fall was less sharper (Meaning it was relatively strong)– meaning it was a stock ready to rise as soon as markets recovered – and it did so sharply in the last few days. Now it may possibly have reached extremes on relative prices so it is likely to perform equivalent to market or may even consolidate even when markets rise. A large number of potential scernarios emerge by just adding this relative chart!
Also, applying a technical indicator on the RS itself like we have done here may allow even better timing on entries and exits even within the overall price action.
Using this Indicator
You can use any technical indicator and chart analysis on the RS, such as a moving average or double top/double bottom.
RS can give you a heads up on rapid change in the price which is a main reason traders use RS. Another reason is that traders prefer buying leaders in the market so buying a stock that shows relative strength makes sense. There is no reason to buy a lagging stock which is only going up because the market is dragging it up.
With this information, you can see which market sectors are outperforming or underperforming the overall markets. If you plan to take a long position, it would be better to be in a well performing sector. You could stop there, choosing a composite index or exchange traded fund and trading on the uptrend. The idea would be to invest in the sectors that are turning up, and to move out of the market sectors where the relative strength lines are turning down.
Performing a relative strength analysis between individual stocks in the sector and the sector index versus the markets is a very powerful way of selecting stocks. By doing this, it’s easy to see which stocks have the greatest relative strength. These are exhibiting a strong uptrend, by being the strongest performers within a strongly performing sector, and therefore they are prime candidates for a trend following trading plan.
Another way to use this information is to go for a cheaper stock where the relative strength index is just turning up, in anticipation that it will continue to improve. You should avoid stocks where the relative strength index is going down like possibly the illustration above.
When using RS for entries, a good idea is to look for divergence as this is when price makes a higher high but the RS makes a lower high. This gives the trader extra evidence when going short. The RS has already told us that it does not support the new high.
Another way using RS for entries is to use it for the analysis of your entries. Look for a relative strong stock and an uptrend in that stock. This tells you that it is climbing faster than for example Nifty and this increases the odds for a successful trade.
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