Our previous newsletter in this mini-series introduced the concept of Relative Strength. We explored its definition and significance in trading strategies. Essentially, Relative Strength involves assessing the performance of one asset (like a stock, commodity, or currency) against another. This comparative analysis can be conducted across different asset classes, individual stocks, or market indices. We had introduced the concept of Numerator and Denominator in the context of Relative strength analysis.

In today’s newsletter, we will try to gain a better understanding on the concept of Numerator and Denominator and see how this understanding will help us decode the nature of Outperformance or Underperformance.

Numerator and Denominator and the logic of Relative strength

Relative Strength, at its core, is about comparing how well one thing performs in relation to another. To grasp this concept better, we can draw a parallel to fractions. In fractions, we compare one value ('a') to another ('b'). Here, 'a' represents the numerator – the value being compared. 'b', the denominator, represents the value against which the numerator is being compared. Again, the numerator and the denominator can be an asset, stock, or an index. In this newsletter, we will use a stock as the numerator and an index as the denominator.

A stock is said to be outperforming when its performing better than the index.
A stock is said to be underperforming when its performing worse than the index.

Lets understand this through an example:

Let us say that for a particular period, the stock’s price increased by 2% and the index increased by 1%. In this case, the stock performed better than the index. This can be understood as outperformance

If, in the same period, the stock declined by 2% but the index rose by 1%, then the stock performed worse because it declined even though the overall market performed better. This can be understood as underperformance.

Nature of Outperformance or Underperformance

The example above shows only one way to interpret outperformance and underperformance. In simple words, outperformance is when the stock is performing better than the index. But what if, for a particular period, the stock was flat, but the index declined? Wouldn’t this also mean that the stock performed better than the index and therefore outperformed? The same logic goes for underperformance. If the stock was flat, but the index rose, this shows underperformance by the stock.

Therefore, we can use different scenarios to understand the nature of out- or underperformance of the numerator against the denominator. Below is a table that will help you understand this concept with clarity. The nature has been classified into 3 categories - Strong, Medium, and Weak:

The stock's performance relative to the index, whether outperforming or underperforming, can vary in nature. This variation depends on the trend or behavior of the denominator. The table above plays a crucial role in understanding these dynamics. It provides insights into the patterns of Relative Strength and helps us visualize ratio charts effectively.

In future newsletters, we will delve deeper into the patterns of Relative Strength, how they appear on charts, and the tools used to analyze Relative strength. Stay tuned for more insights!

Relative strength is only a tool to analyze how an instrument is performing vis-a-vis another instrument. This tool is effective when combined with chart reading. Check out TNT One membership. This exclusive membership gives you access to the largest library on technical analysis. If this newsletter got you intrigued about trading, do check it out.

👇🏻👇🏻👇🏻