What it is and how to apply to financial markets
What is Relative Strength?
The definition of relative strength, put one basic way, is a momentum technique that compares a particular stock or financial instrument, as compared to that of the overall corresponding market. This is a fundamental tool that is used to calculate which investments are stronger/weaker performers.
A basic example is using the Dow Industrial Average as a way to show relative strength based upon the above definition. Suppose on a given day, the Dow, comprised of 30 stocks is down 2% on that day. Assuming this example is a “broad-based” selloff, all 30 Dow Stocks would be negative or in the red. But per say IBM, a Dow stock, is positive on the day. IBM is showing relative strength as compared to the index and most likely its peers. Granted there might be material news or even abnormal volume but IBM is still displaying relative strength.
How to apply relative strength principles to Forex and the Equity markets:
Understand there are different formula’s that can calculate a Relative Strength Index, or RSI, that many traders use. These formulas are either a standard query or a lot of times a formula that any individual can create usually predicated on price action, trend, and volume. For the Forex and/or equity examples, I will demonstrate the basic theory and not any empirical formula(s) to simplify things.
When it comes to the Forex markets and determining the relative strength of a currency, it’s important to identify whether that currency, say the Dollar, is in a bullish or bearish trend against a basket of other currencies. Note, regardless of market opinion, put your ego aside. A trend is still a trend. If the Dollar is in an upward trend against a basket of currencies, we can apply this towards buying/selling the currency against the Dollar.
The equities markets are a little more complex due to the fact that there are other mitigating factors that we can use to identify relative strength. The most important is once again, identifying trend. Not only when it comes to any indexes but for that particular stock and even so, the group that the stock trades in. Further example to follow.
Recognizing/Applying Relative Strength in Trending Market(s):
First of all, a trader using even the basic relative strength principles should be aware that volatility, especially in shorter time frames, will affect the RSI in a more dramatic or even false fashion. But for this example, we will use the United States Banking Sector. A current sector in a bullish uptrend but one prone to geo-political news as well as fundamental news in the sector. Say Citigroup (C), Bank of America (BAC), Morgan Stanley (MS), Goldman Sachs (GS) are weak on a day when the market is down modestly. Remembering the market and sector are in bullish uptrends but Wells Fargo (WFC) is unchanged or even up on the day. WFC is therefore showing relative strength against the market and group and to many, myself included, would consider buying WFC because if the market were to rally, showing its current uptrend and obvious strength would likely rally as well.
Say the market did rally. The banks, in their uptrend, more than likely would rally as well. But say the weakest acting stock in that group, Bank of America, did not rally or didn’t rally “as much as it should” and you decided to buy the laggard in the group. More times than not, Bank of America would not bounce or rally as much as their stronger acting peers. If the market were in a downtrend and banks were in weak trend, then conversely, Bank of America would be on my list to look at as a possible short… assuming there was price action and volume.
Pitfalls to using Relative Strength:
With over 20 years of trading experience at a high level, I have found that many traders apply the relative strength principles without regard to recognizing a clear trend in the market they are dealing with and even the entity to which one choses to “play”.
Example: Assuming the US Financial stocks, some mentioned above, are in the clear uptrend and appreciating with the corresponding US indices. If you have 9 out of 10 Bank stocks that are positive and there will be some up greater than others but Bank of America (BAC) is down on the day. Assuming there is no material news on BAC and IS showing relative weakness to the group, many traders decide to short BAC because it is blatantly showing relative weakness. But most traders lose on that trade because if the market rallies and bank stocks are outperforming, than most likely BAC would rally or “squeeze” as well, thus continuing its current uptrend. The way to play the above scenario would be to buy the leader’s and not short the laggard due to the current uptrend in markets and financial stocks… although I would note that BAC was weak in a strong market and would keep on the radar for a weak financial day.
In closing, within a group of stocks or any other investments, some perform better than others. Using RSI indicators and the Relative Strength theory recognizes these differences in performances and thus allowing the trader an additional edge to one’s investment strategy.