Updated: 11/01/2023

Mastering Trading with Relative Strength: A Comprehensive Guide

understanding relative strength
.18 Sep 2023
author avatar image Chad Smith

Table of Contents

In the fast-paced and volatile world of trading, making informed and wise investments is no less than an art. One of the pivotal aspects that can significantly steer trading decisions in the right direction is the understanding and apt utilization of relative strength. An in-depth comprehension of this concept acts as a compass, guiding traders towards favourable risk/return ratio comparisons across diverse securities. In this context, our journey begins by unfolding the fundamentals of relative strength, followed by an exploration of methods and indicators for its precise analysis. Further, we navigate how to seamlessly weave relative strength into resilient trading strategies and, critically, acquaint ourselves with its potential limitations and risks.

Understanding Relative Strength

Understanding Relative Strength

In the world of trading, relative strength is a momentum-based indicator that compares the magnitude of recent gains to recent losses in an effort to determine the overbought and oversold conditions of an asset. Often confused with Relative Strength Index (RSI), relative strength is fundamentally different. Technically speaking, the term ‘relative strength’ refers to the comparison of the performance of an individual security to a market index or to another security.

Application of Relative Strength in Trading

The concept of relative strength is used extensively in momentum investing where traders select stocks that have been showing a trend with an expectation that the trend will continue. Relative strength can be used to discover the strongest trends within the market, and identify the period when these trends might reverse. Traders use relative strength to gauge the performance of a stock, sector, or an index in comparison to the rest of the market. This enables them to spot market outperformers or underperformers, giving them an edge in their trading decisions.

Calculating Relative Strength

Relative strength for a stock is calculated by taking the percentage gain for a specified period and dividing it by the percentage gain for another stock over the same period. This ratio will give you an indicator of the relative strength of the two stocks. If the ratio is greater than 1, the stock is performing better than the comparator stock; if the ratio is less than 1, the stock is underperforming in comparison.

Factors Influencing Relative Strength

There are many factors that might influence the relative strength of a specific security or market sector. These factors might include broader economic indicators, such as changes in Gross Domestic Product (GDP) or unemployment rate, industry-specific phenomena or trends, the state of the financial markets, overall investor sentiment, and the financial health of the specific company whose stock is being analysed.

Relative Strength and Risk/Return Ratio

Understanding relative strength within the context of the risk/return ratio can be beneficial. By using the risk and return matrix, traders can optimise asset allocation and enhance their trading strategy. Relative strength, when used in combination with other technical indicators or trading strategies, can be an effective tool to achieve a risk/return ratio that is consistent with a trader’s specific risk profile and investment objectives.

Grasping the concept of relative strength in different securities and implementing it in your trading approach is a valuable asset in the financial market. It’s about much more than just identifying the highest return—it also involves managing risk and selecting securities that exhibit strong performance relative to their respective market or sector. By making more knowledgeable and strategic decisions, one can achieve superior outcomes in their trading ventures.

Image depicting the concept of relative strength in trading, showing different arrows representing the performance of securities in comparison to the market.

Methods and Indicators in Analyzing Relative Strength

Understanding the Relative Strength Index (RSI)

The Relative Strength Index (RSI), coined by J. Welles Wilder, enjoys widespread use as one of the most reliable means of assessing relative strength in trading. This momentum oscillator accurately measures the velocity and fluctuation of price movements. The RSI swings between zero and 100, with a value above 70 traditionally signifying an overbought condition, whilst a value below 30 implies an oversold scenario.

Calculating the RSI

Calculation of RSI involves two steps: calculation of the gains and losses over a specified period, typically 14 periods, and then the calculation of the average gain and average loss. This leads to the calculation of the relative strength (RS), which is the average gain divided by the average loss. The RSI is then derived from this, being 100 minus [100 divided by (1+RS)].

Interpreting the RSI

When the RSI is above 70 it indicates that a security is becoming overbought or overvalued and may be primed for a trend reversal. Conversely, if the RSI is below 30, it is an indication that a security is oversold or undervalued and may become due for a trend correction. The RSI can stay at these levels for extended periods during a strong trend.

Relative Strength Charts

Another commonly used tool in trading is relative strength charts. These charts compare the performance of one security or index to another. This can be an effective way to identify sectors or stocks that are outperforming or underperforming the market. It offers traders an insight into the sectors or stocks that demonstrate the greatest strength or weakness.

A rising relative strength line indicates that the security is outperforming the market. Conversely, a falling line indicates underperformance. These charts can be particularly useful during periods of market volatility, as they can help identify sectors or stocks that are most resilient or most vulnerable.

Other Significant Tools in Analysing Relative Strength

In addition to the RSI and relative strength charts, traders might also use other tools such as moving averages, the MACD, or Bollinger Bands. These tools can provide different perspectives on the momentum and relative strength of a security or market. A MACD, or Moving Average Convergence Divergence, for example, tracks the relationship between two moving averages of a security’s price. Bollinger Bands, named after their creator John Bollinger, provide a relative definition of high and low prices of a market.

Conclusion

To conclude, relative strength trading embodies a diversity of tactics and indices, such as the RSI and relative strength graphs. Gaining a solid comprehension of how to compute and interpret these elements can result in crucial awareness on market tendencies and prospects. Nonetheless, as always, it’s essential to deploy them alongside other kinds of study and requisite diligence.

A visualization showing the comparison of relative strength between different securities, indicating their performance in relation to the market.

Incorporating Relative Strength in Trading Strategies

Grasping the Concept of Relative Strength

Relative Strength is a principle in technical analysis that necessitates the comparison of two assets’ performance to forecast which one will excel. Traders utilise this method to compare the price performance of two securities, regularly, those belonging to the same industry. Such techniques allow the identification of the dominant contenders within a particular market segment.

Importance of Relative Strength in Trading

The primary benefit of using relative strength in trading is the ability to identify strong against weak assets. By comparing two assets, a trader can identify which one is likely outperforming the other. Traders often utilise this tactic in an effort to always trade in the direction of the stronger asset.

Incorporating Relative Strength in Trading Strategies

Incorporating Relative Strength into a trading strategy can be relatively straightforward. Traders generally begin by selecting two assets within a related field or sector. They then compare the performance of these assets over a specified time period. This comparison yields a relative strength ratio.

The relative strength ratio is derived by dividing the price of one security by another. If the ratio is increasing, then the numerator is performing better than the denominator. However, if the ratio is decreasing, it signifies the opposite.

Timing the Market with Relative Strength

Market timing is a critical aspect of successful trading. By using the relative strength approach, traders can make more informed decisions about when to enter or exit a trade.

If a security has a rising relative strength ratio, it could be a sign that this is the optimal time to purchase. A trader who spots a falling relative strength ratio might take it as a signal to sell. It’s crucial to remember, though, that other factors should also be taken into consideration – market timing should never rely on one indicator alone.

Identifying Trends with Relative Strength

Relative strength can be a valuable tool in identifying market trends. If the relative strength line is moving upwards, it suggests that the chosen asset is outperforming the other.

Traders can take this as a bullish signal. Alternatively, if the relative strength line is declining, it might indicate that the asset is underperforming, a bearish signal. As such, traders can employ relative strength analyses to spot potential trend reversals or continuation patterns early.

Opting for Vigorous over Feeble Assets

One of the revealing benefits of applying relative strength in trading is its beneficial use in electing robust as opposed to weaker assets. Studying related securities’ performances may assist in figuring out which one offers a more bullish prospect, leading to a more tailored investment decision.

Overall, incorporating relative strength into trading strategies has the potential to streamline the selection process, fine-tune market timing, and provide valuable insights into overarching market trends. However, it’s important to note that these strategies and indicators should serve as a supplement to other tools and not the crux of your trading decisions. Likewise, it’s crucial to remember that past performance doesn’t guarantee future outcomes.

An image depicting a line chart showing the relative strength of two assets over time.

Potential Risks andLimitations of Relative Strength

Recognising the Hazards of Relative Strength Trading

Engaging in trading using relative strength involves analysing past price patterns to prophesy prospective movements. Investors who are confident in this strategy lean on a stock or any other asset’s past performance to predict its future outcomes. More often than not, relative strength is applied in tandem with other types of analyses, such as technical or fundamental analysis.

Over-reliance on Past Performance

A common mistake with relative strength trading is over-reliance on historical data. Traders often believe that because a stock has performed well in the past, it will continue to do so in the future. While history can indicate a possible trajectory, it is not a definitive predictor of future performance. External factors such as changes in the economy, industry trends, and company fundamentals can significantly affect future performance.

Market Volatility

Market volatility is another risk associated with relative strength trading. Stock prices can fluctuate greatly over short periods, and the relative strength of a stock can therefore change rapidly. In periods of high volatility, reliance on relative strength alone may lead to poor trading decisions as it fails to take into account the changing market conditions.

Changes in Company Fundamentals

The relative strength analysis is technical in nature, focusing on price and volume. It doesn’t consider changes in company fundamentals that can hugely impact a stock’s value. Events like changes in management, new product launches, company scandals, or earning reports can dramatically alter a stock’s price. Traders using relative strength must balance it with fundamental analysis to gain a holistic overview of a company’s health.

False Signals

Finally, relative strength trading can result in false signals. This happens when a stock’s price movement indicates a certain trend, but the trend doesn’t continue as expected. This can happen due to a number of factors such as market volatility or changes in company fundamentals. Traders relying solely on relative strength for their trading decisions may end up executing trades based on these false signals, which can lead to losses.

The Balanced Approach

Relying solely on relative strength for decisions is a risky strategy. To mitigate these risks, traders should adopt a balanced approach that incorporates other forms of analysis. Fundamental analysis, which evaluates a company’s financial health and market position, can provide valuable context to a stock’s relative strength.

In conclusion, while relative strength can be a useful tool in an investor’s arsenal, it should not be the only one. With a comprehensive understanding of its risks and limitations, and by combining it with other analytical methods, traders can use relative strength to make informed and balanced trading decisions.

Illustration of a stock market chart with arrows indicating price movements, representing the risks and limitations of relative strength trading

Undeniably, trading is not a gamble but stands on the robust pillars of skill, knowledge, strategy and adaptability. While technical analysis and tools like relative strength constitute a significant part of the knowledge pool, they shouldn’t be perceived as the ultimate guiding lighthouse. Equally essential is the cognizance of potential risks and common pitfalls, the art of striking a balance between technical and fundamental analysis, and maintaining the ability to adapt to the ever-changing market dynamics. As we broaden our horizons about relative strength, its applications, and the need for a comprehensive, balanced approach to trading, our intention is to empower every professional in their quest to master the art and science of trading.

author avatar image
Chad Smith

Chad Smith is the Director of Research & Analysis here at ForexBrokerListing.com. Chad previously served as an Editor for a number of websites related to finance and trading, where he authored a significant number of published articles about trading and the impact of technology in transforming investing as we know it. Overall, Chad is an active fintech and crypto industry researcher with more than 15 years of trading experience, and you can find him teaching his dog how to trade in his free time.