Utilizing Relative Strength in Trading

Utilizing Relative Strength in Trading

Did you know that Relative Strength can be a valuable tool for identifying strong stocks to trade? Indeed, Relative Strength serves as a momentum strategy that aids in pinpointing robust stocks in comparison to the broader market index.

Through Relative Strength analysis, traders seek out companies that have demonstrated superior performance when compared to their peers or the overall market index. This approach involves identifying stocks that have shown resilience by either rising more or declining less compared to their counterparts or the market index.

The application of Relative Strength assists traders in anticipating the continuation of prevailing trends in these stocks, leading to potential positive returns. It's important to note that Relative Strength should not be confused with the Relative Strength Index.

Let's delve into the concept of Relative Strength, its calculation, and how it can be employed in trading:

Understanding Relative Strength (RS) Relative Strength assesses a stock's performance relative to a benchmark or another stock. It measures how stock "X" fares against stock "Y" over a specific period. For instance, in a rising market, "X" might experience more significant gains or milder losses compared to "Y," or in a falling market, "X" could experience greater or milder losses than "Y."

Relative Strength is categorized as a momentum indicator. Momentum indicators help traders gauge the speed at which a stock's price changes, offering insights into the intensity of price movements. By utilizing momentum indicators, traders can decipher whether stock prices are rapidly or slowly rising or falling.

Relative Strength aids in the identification of both the strongest and weakest securities or asset classes within financial markets. Stocks that consistently exhibit strong or weak Relative Strength over a given period tend to maintain their performance patterns. This analysis can be extended to domestic or international stocks, stock indexes, fixed-income indexes, currencies, commodities, and other asset classes.

To understand Relative Strength better, let's briefly revisit the concepts of beta and alpha:

Beta and Alpha: Their Relevance Beta is a measure of volatility in relation to a benchmark. It quantifies the systematic risk of a security or portfolio in comparison to an index such as the Nifty 50.

Alpha, on the other hand, is the excess return of an investment or stock, accounting for market-related volatility and random fluctuations. Alpha gauges whether an asset consistently outperforms or under performs its predicted beta. An Alpha greater than 0 signifies out performance, while a negative Alpha indicates under performance, accounting for volatility.

High-beta stocks can be more profitable but also carry higher risk. These stocks could have a negative alpha, suggesting that despite higher volatility, they might exhibit downward trends. When comparing Alpha values among stocks, it provides a measure of relative strength, helping rank stocks accordingly.

Calculating Relative Strength The calculation of RS involves comparing the price changes of one stock to another or an index. The formula for calculating RS is as follows:

RS = Stock’s Price / Index’s Price

For comparing the RS of two stocks, "N" and "N1," the formula becomes:

RS = N Stock’s Price / N2 Stock’s Price

Both assets should have the same time frame, such as a day or a year.

Applying Relative Strength in Trading Understanding RS calculation, let's explore how to trade stronger stocks using RS. Consider the example of Reliance India Ltd. in the chart below:

In the depicted daily chart of Reliance India Ltd., the RS line (blue line) is plotted against the Nifty 50 for the past 50 periods.

When the RS line crosses above 0, the stock is outperforming the index, while crossing below 0 signifies under performance. For instance, on March 11, the RS line crossed below 0, coinciding with the onset of a bearish phase in the stock. This indicates weakening performance and under performance against the index. Traders can capitalize on this by shorting, riding the downtrend, and gaining profits until the RS line surpasses 0.

Traders should complement RS analysis with other technical indicators such as Super Trend, moving averages, and volume.

Implementing Relative Strength with Stock Edge Stock Edge provides tools to filter stocks that are either outperforming or under performing the index or sectors based on Relative Strength scans. For instance, the 'Strongly Outperforming Benchmark Index' scan highlights stocks with RS > 0.1, denoting out performance.

By applying these scans, traders can easily identify stocks that have exhibited either strong out performance or under performance against the index or sector over the past 55 days.

Relative Strength vs. Relative Strength Index (RSI) Distinction between Relative Strength and Relative Strength Index (RSI):

Relative Strength measures a stock's value in comparison to other stocks, indexes, or sectors. In contrast, RSI is a momentum indicator that gauges the recent price changes of a stock to determine overbought or oversold conditions.

Relative Strength provides a comparative perspective, whereas RSI evaluates a stock's performance relative to its recent history.

Learning Relative Strength (RS) To gain a deeper understanding of Relative Strength, one can explore webinars conducted by market experts. These webinars cover various aspects such as:

1.     Getting Stock Ideas with RS

2.     Identifying Master-Blaster Stocks with RS

3.     Systematic Trading Using RS

4.     Trading Using Crossovers and RS

5.     Developing a Trading Strategy Using RS

Conclusion Trading with Relative Strength necessitates a well-defined strategy. Traders shouldn't randomly select strong stocks; instead, they need a trading plan outlining entry and exit points, risk management, and position sizing. Relative Strength serves as a valuable tool for identifying strong stocks, and utilizing it with other technical indicators can enhance trading decisions. By using tools like Stock Edge, traders can identify stocks that outperform or underperform the index or sectors, facilitating informed trading choices.

Article Source - https://blog.elearnmarkets.com/trading-with-relative-strength/