Relative Strength Charts

Relative Strength (RS) charts empower traders by quickly highlighting which assets are gaining momentum and which are losing it; this information allows traders to make well-informed decisions, enhancing their chances of success in the financial markets

18 minutes

Introduction: A broad outline of Relative Strength Charts

Relative strength charts, also known as relative strength analysis or relative strength comparison charts, are a type of financial chart used in technical analysis to compare the performance of one security or asset against another, typically in relation to a benchmark index or another asset. These charts are useful for investors and traders to assess the relative performance of different assets and make informed investment decisions.

Here are some key points to understand about relative strength charts:

Purpose: The primary purpose of relative strength charts is to assess how one asset or security is performing in comparison to another. This can be used to identify potential investment opportunities, determine which assets are outperforming the market, or evaluate the strength of a particular security in relation to a benchmark.

Calculation: Relative strength is typically calculated by dividing the price of one asset by the price of another asset or index. The resulting ratio is then plotted on a chart over time, creating a visual representation of the relative performance.

Benchmarking: In most cases, investors use a benchmark index (such as the NIFTY or NIFTY500) as a point of reference. The relative strength of a stock or asset is compared to the benchmark’s performance over the same time frame.

Interpretation: If the relative strength line is rising, it suggests that the asset in question is outperforming the benchmark or the comparison asset. If the relative strength line is falling, it suggests that the asset is underperforming the benchmark or comparison asset. A flat or stable relative strength line suggests that the asset’s performance is roughly in line with the benchmark.

Trading Strategies: Traders and investors can use relative strength analysis to identify assets that are showing strength and may continue to perform well. For example, they may seek to buy assets with rising relative strength and avoid or sell assets with declining relative strength.

Time Frames: Relative strength analysis can be applied over various time frames, from short-term intraday comparisons to longer-term trends. The choice of time frame depends on the investor’s goals and trading strategy.

Sector and Industry Analysis: Relative strength can also be applied to sectors and industries within the stock market to identify those that are performing better or worse relative to the broader market.

Software Tools: Many financial analysis software, like ChartAlert, and trading platforms provide tools to create and analyze relative strength charts. These tools can make it easier for investors to conduct this type of analysis.

Limitations: It’s essential to remember that relative strength analysis does not provide specific buy or sell signals. It’s a tool to assess relative performance and identify trends. However, it does not consider other fundamental or technical factors that might affect an asset’s performance.

In summary, relative strength charts are a valuable tool in the world of technical analysis for assessing the performance of assets in comparison to a benchmark or other assets. They can help traders and investors make more informed decisions about their investment portfolios.

Origin of Relative Strength Charts

Relative strength charts have been an essential component of technical analysis for decades. While their precise origin is challenging to pinpoint, Charles Dow, a pioneer in technical analysis, laid the foundation for this methodology with his Dow Theory in the late 19th century. Dow emphasized the importance of comparing the performance of different assets, an idea that remains central to relative strength analysis today.

A.W. Cohen and Relative Strength

A.W. Cohen, a well-respected authority in the field of technical analysis and associated with Chartcraft, is celebrated for his significant contributions to the idea of relative strength. While he wasn’t the originator of relative strength charts, he played a crucial part in popularizing them and transforming them into a valuable tool for individuals involved in trading and investing.

Cohen’s main contributions to relative strength charts and technical analysis include:

Cohen is known for introducing the concept of relative strength rankings. He emphasized the importance of comparing the performance of individual securities within a particular market or sector. This idea led to the creation of rankings that help traders and investors identify the strongest and weakest performers, making it easier to make informed investment decisions.

Cohen made a clear distinction between relative strength and absolute strength. While absolute strength looks at an asset’s performance in isolation, relative strength compares an asset’s performance to that of other assets or a benchmark index. He highlighted the relevance of relative strength for investors, as it provides a context for assessing an asset’s performance in relation to the broader market.

Thomas Dorsey and Relative Strength (and the RS Matrix)

Thomas Dorsey is a widely recognized expert in technical analysis and the author of the book ‘Point & Figure Charting: The Essential Application for Forecasting and Tracking Market Prices’. He has significantly advanced the field of technical analysis, particularly in the area of applying Relative Strength.

Dorsey is most renowned for creating the Relative Strength Matrix method, which involves evaluating how well a particular investment performs compared to similar investments and a relevant market benchmark. This method aids traders and investors in pinpointing assets that are currently displaying strong performance and are likely to continue doing so. Essentially, it simplifies the task of assessing and ranking assets based on their relative strength.

Additionally, Dorsey has authored numerous books and educational materials centered on technical analysis and relative strength. His publications have played a crucial role in educating and guiding traders and investors on effectively utilizing relative strength charts to inform their decision-making processes.

Dorsey’s contributions have been pivotal in making the concept of relative strength more understandable for a broader audience, and his methods have been widely embraced by traders and investors who are looking to identify strong and weak performers in the market.

Jeremy du Plessis and Relative Strength

Jeremy du Plessis, a distinguished figure in the realm of technical analysis, has made significant contributions to the comprehension and practical application of relative strength charts. His expertise is well-regarded, and he has authored various books and educational materials on technical analysis and relative strength. Below are some of Jeremy du Plessis’s notable contributions and insights:

In this authoritative book, ‘The Definitive Guide to Relative Strength Investing’, du Plessis explores the concept of relative strength, elucidating its significance and real-world applications for both investors and traders.

Du Plessis stresses the pragmatic use of relative strength analysis. He offers clear and actionable techniques for employing relative strength to identify robust-performing assets and sectors. This practical approach proves invaluable to those seeking to incorporate relative strength into their trading and investment strategies.

A core theme in du Plessis’s work is the importance of choosing assets and sectors with robust relative strength. By comparing their performance to an appropriate benchmark, traders and investors can pinpoint opportunities for superior performance and make well-informed decisions regarding capital allocation.

Du Plessis delves into risk management and portfolio allocation within the context of relative strength. He underscores the role of relative strength in optimizing portfolio diversification and risk control. Opting for assets with strong relative strength can potentially reduce exposure to underperforming assets and enhance the overall performance of a portfolio.

Du Plessis provides strategies for identifying robust trends through relative strength analysis. By monitoring relative strength across various time frames, traders can identify entry and exit opportunities based on an asset’s performance relative to the broader market.

In summary, in the realm of technical analysis, A.W. Cohen, Thomas Dorsey, and Jeremy du Plessis stand as revered figures who’ve significantly influenced the advancement and popularity of relative strength charts. While they aren’t the originators of this concept, their contributions in refining and promoting relative strength analysis have left a lasting imprint on how traders and investors employ this invaluable tool in the world of finance.

Their contributions encompass educational materials, practical guidance on implementing relative strength, a focus on sector and asset selection, risk management, and the identification of robust trends. Their work has played a pivotal role in assisting traders and investors in comprehending and effectively utilizing relative strength analysis in their decision-making processes within financial markets.

Constructing Relative Strength Charts

The formula for computing relative strength is relatively straightforward:

Relative Strength = Price of Asset A / Price of Asset B

This ratio is then plotted over time, creating a visual representation of the relative performance of Asset A compared to Asset B.

When the relative strength line is ascending on the chart, it signifies that Asset A is outperforming Asset B. Conversely, a declining relative strength line indicates underperformance of Asset A relative to Asset B.

There are two primary Relative Strength (RS) charts that analyze the performance of an individual stock. The first RS calculation compares the stock’s performance to the broader market. This RS reading is determined by dividing the stock’s price by the market index price and then multiplying the result by 100, following this formula:

RS = (Stock Price / Market Index Price) x 100 = (INFY / NIFTY)

The second type of RS calculation assesses the stock’s performance relative to another specific stock. In this case, the RS reading is computed by dividing the stock’s price by the price of the other stock in question and then multiplying the outcome by 100, following this formula:

RS = (Stock Price / Other Stock Price) x 100 = (INFY / TCS)

It’s important to note that both of these calculations utilize closing prices, and they are performed on a daily basis.

A Point & Figure Relative Strength chart in an uptrend with X’s indicates that the stock or sector is displaying significant strength. It is performing better than the benchmark on both a long-term and short-term basis. On the other hand, a P&F RS chart in a downtrend with O’s suggests that the stock or sector is notably weak. It is underperforming the benchmark on both long-term and short-term horizons.

The Significance of Relative Strength Charts, and how to effectively make use of them in trading

Relative Strength (RS) is a method used to gauge how well one financial asset is performing in comparison to another. Although it may seem quite simple, it has repeatedly demonstrated its effectiveness in consistently outperforming the broader market.

Relative strength is a fundamental element of successful investment strategies because it enables investors to identify strong-performing assets, often referred to as ‘positive outliers’ or ‘big winners’, while also helping them steer clear of poor-performing investments.

In fact, it’s worth noting that Jim O’Shaughnessy’s research, as outlined in his book ‘What Works on Wall Street,’ had showed that relative strength played a pivotal role in all of the top 10 performing investment strategies he had examined.

Thus, relative strength charts play a crucial role in the world of technical analysis, offering investors and traders valuable insights into the relative performance of assets. Understanding their significance is essential for making informed investment decisions. Here are some key aspects of their importance:

Identifying Outperformance and Underperformance

RS charts are a valuable tool for investors and traders in identifying assets that either outperform or underperform a benchmark index or another asset. This distinction is crucial for making informed investment decisions.

When a security or asset displays an ascending relative strength line on the chart, it signifies that it is outperforming the benchmark or a reference asset. Conversely, a declining relative strength line indicates underperformance. This information is instrumental in guiding investors in selecting assets for investment or divestment.

Another primary application of RS charts is to recognize assets with strong momentum and trends. By examining the relative strength line, traders can identify assets that consistently outperform the benchmark or other assets.

When the relative strength line is on an upward trajectory, it signifies that the asset is gaining strength compared to its peers. Traders often look for opportunities to buy or hold such assets, as they show potential for continued upward movement.

Timing Investment Opportunities

RS charts also aid in spotting potential investment opportunities. When an asset’s relative strength line starts to rise, it signifies a potential shift in its favor, indicating that it may be on the cusp of a positive trend. This is a signal for investors to consider taking a closer look at the asset for potential investment. Conversely, when a declining relative strength line is observed, it may be an early warning of deteriorating performance, prompting investors to reassess their positions.

Picking Candidates for Shorting

Conversely, RS charts can help traders identify assets with weak relative strength. When the relative strength line is declining, it indicates that the asset is underperforming in comparison to its peers. Traders may consider shorting or selling such assets, betting on their continued underperformance.

Using Point & Figure Relative Strength Charts

To assess how a stock is performing compared to others, you can scan for Relative Strength (RS) reversals, which offer insights into shorter-term trends. In a Point & Figure RS chart, the most recent column gives a snapshot of short-term RS. If the latest column contains X’s, it indicates the stock is currently outperforming. Conversely, if it contains O’s, this signifies underperformance in the short term.

You can also analyze the P&F RS chart for a combined buy signal and a column of X’s, which is the most favorable scenario. Conversely, the least favorable situation is being in an RS sell signal and surrounded by O’s.

An RS buy signal is a chart pattern suggesting a stock is outperforming the market or another stock. This signal occurs when the Point & Figure RS chart transitions from a column of O’s to X’s, triggering a double top buy signal. This implies the stock is gaining strength relative to the market or another stock. The RS buy signal is optimistic, indicating that the stock is likely to continue outperforming in the near term. It’s essential to remember that the RS buy signal is just one factor and should be used in conjunction with other technical and fundamental analysis tools for making investment decisions.

On the flip side, an RS sell signal indicates a stock is underperforming. It appears when the P&F RS chart switches from a column of X’s to O’s, triggering a double bottom sell signal. This signifies that the stock is losing strength relative to the market or another stock. The RS sell signal is pessimistic and suggests that the stock is likely to continue underperforming in the short term. If you own a stock that has just given an RS sell signal, it’s time to assess whether it’s wise to sell that stock.

Spotting Positive Divergences

Identifying positive divergences entails using RS to gauge market divergence when the broader market is facing a downturn. A positive divergence emerges when the RS line is on an upward trajectory while the stock price is declining. This indicates that the stock is gaining strength compared to the overall market, despite its price decreasing. Such a positive divergence can serve as a potentially bullish signal, implying that the stock is poised to reverse its declining trend and potentially ascend. It is crucial to complement RS with additional technical and fundamental analysis tools to validate the signal and make well-informed investment choices.

Sector and Industry Rotation

Traders often employ relative strength charts to monitor and capitalize on sector and industry rotation. By comparing the relative strength of different sectors or industries within a market, traders can discern which areas are currently outperforming or underperforming. This information is valuable for making sector-specific or industry-specific trades and optimizing their portfolio based on market trends.

Diversification and Risk Management

In portfolio management, diversification is essential for spreading risk effectively. RS charts play a crucial role in achieving this goal. These charts enable investors to assess the relative strength of different assets or sectors, providing valuable insights for making informed decisions about portfolio diversification.

For instance, if one sector consistently demonstrates robust relative strength compared to others, it becomes a strong candidate for increased allocation within a diversified portfolio. Conversely, assets or sectors displaying weak relative strength may warrant reduced exposure.

Traders can leverage RS charts to make well-informed choices regarding portfolio diversification and risk management. By evaluating the relative strength of various assets, they can strategically allocate their capital to assets or sectors exhibiting strength, while reducing exposure to those with relative weakness. This approach not only helps in spreading risk but also optimizes returns.

Measuring Relative Strength Over Different Time Frames

RS charts offer adaptable utility across multiple time frames, catering to various investment strategies. They provide a valuable tool for investors with diverse time horizons. Short-term traders can employ shorter time frames to capture transient trends, while long-term investors may utilize longer time frames to evaluate asset strength over extended periods. This adaptability enables traders to align their choice of time frame with their specific trading strategies. Intraday or daily charts serve short-term traders seeking quick momentum opportunities, while weekly or monthly charts are favored by long-term investors for identifying assets with enduring strength.

Integration with Other Analysis Methods

Investors and traders frequently integrate RS charts with a range of analytical tools to refine their decision-making. By incorporating moving averages, trendlines, technical indicators, and fundamental data alongside relative strength analysis, they can attain a comprehensive understanding of an asset’s potential performance. This comprehensive method yields a multifaceted market perspective, reinforcing confidence in trading and investment choices.

In summary, Relative Strength Charts serve as a valuable window into asset performance, offering systematic comparisons and insights into outperformance, underperformance, and investment timing. Thoughtfully employed alongside other analytical methods, they become a vital asset in an investor’s toolkit.

Effective utilization involves identifying trends, recognizing momentum, pinpointing trading opportunities, and extends to risk management and portfolio optimization. When integrated with other tools within a comprehensive trading strategy, Relative Strength Charts provide traders with a significant advantage in the financial markets.

Advantages & Limitations of using Relative Strength Charts

Here are some advantages and limitations of using relative strength charts in trading:

• Simplicity: Relative strength charts are easy to understand and apply.
• Timely Information: They provide quick insights into trends and relative performance.
• Objective Comparison: They offer an objective basis for asset comparisons.

Limitations

• Lack of Context: relative strength charts don’t consider underlying fundamentals.
• Market Volatility: In highly volatile markets, relative strength may not be a reliable indicator.
• Over-Reliance: Relying solely on relative strength analysis may lead to overlooking other critical factors.

Relative strength charts are invaluable tools for investors and traders, offering a clear perspective on asset performance relative to benchmarks. When used judiciously in combination with other analyses, they can contribute to informed decision-making.

It’s crucial to remember that relative strength charts are just one part of the financial analysis puzzle. They do not guarantee trading success and should be used in conjunction with other tools and research.