In this series on Relative Strength (RS), we began by exploring its foundational logic and understanding how it can give traders a significant edge. Following that, we delved into decoding outperformance and underperformance through the concepts of the numerator and denominator.

The previous newsletter, which focused on the nature of performance, is particularly crucial for recognizing and interpreting patterns in Relative Strength. If you haven’t had a chance to read it yet, it is highly recommend doing so—it serves as a critical stepping stone for making the most of this series

In today’s newsletter, we will explore the 6 patterns of Relative strength. Also, we will learn how to use these patterns. But before this, we will learn about the Ratio chart in Relative strength.

Ratio Charts

The essence of technical analysis lies in plotting an instrument's price movements on a chart to analyze and predict future price trends. But what if the same approach could be applied to relative strength charts?

Relative strength involves comparing the performance of one instrument against another. As discussed in the previous newsletter, this comparison can be represented as fractions, resulting in a ratio of the numerator to the denominator. This ratio can then be plotted on the chart to show outperformance or underperformance of the numerator.

For example, Lets say the price of a stock and index over a period of 10 days is as follows:

This will result in a ratio of as follows: 1.0, 0.9, 0.86, 0.87, 0.85, 0.91, 0.77, 1.09, 1.4, 1.66. These ratios can be then plotted on the chart, just like a price chart, resulting in a ratio line chart.

In simple terms, the ratio line will rise when the numerator outperforms, and it will fall when the numerator underperforms, regardless of the type of performance. If the performance of the numerator is same as the denominator, then the ratio line will be flat, therefore showing a consolidation on the chart.

Similar to other charts, the Ratio chart offers multiple timeframes, including 15-minute, daily, weekly, monthly, and more. It compares the performance of the numerator with that of the denominator, aligning both to the same timeframe as the chart's selected interval.

The Patterns

There are 6 patterns of Relative strength: 3 of Outperformance and 3 of Underperformance.

The patterns of Outperformance are:

1. Flying Pattern,

2. Lion Pattern, and

3. Bullish star Pattern

The Patterns of Underperformance are:

1. Drowning Pattern,

2. Cat Pattern, and

3. Bearish star Pattern

Let us understand each pattern in depth now. In the following examples, the numerator is a stock, and the denominator is a broad market index Nifty 50 (signifying the overall market trend).

Flying Pattern

Numerator is rising, Denominator is rising, resulting in a rising ratio line

This is a strong outperformance pattern. The index is in an uptrend, indicating a bullish environment, and the stock is also on the rise, reflecting its own upward trend. As discussed before, rising ratio line shows outperformance. A rising ratio line indicates that the stock is outperforming the index, showcasing stronger performance compared to the overall market.

An index in an uptrend shows that the environment is bullish, suggesting positive sentiments, healthy macro and micro indicators. When the trader wants to trade bullish, this is the pattern to look for on Ratio chart. The important element in this pattern is the index (Denominator) is bullish.

Lion Pattern

Numerator is rising, Denominator is falling, resulting in a rising ratio line

This relative strength pattern is another strong outperformance pattern. This pattern shows the strength of the numerator, which has not declined even though there is a bearish market environment. Although the numerator is in an uptrend, the problem is that the market environment is not bullish. There can be a possibility that these stocks can decline as well. To use Lion pattern effectively, make a list of stocks displaying this pattern and wait for the market trend to turn bullish. These can be potential flying patterns when the market turns bullish.

Bullish star pattern

Numerator is declining, Denominator is declining, rising ratio line

This pattern is a variation of the Lion pattern and shows outperformance. The denominator is falling and in a bearish trend. The numerator, however, is falling but less than the numerator therefore showing outperformance. The strategy would be to wait for the denominator’s trend to stabilize and turn bullish before participating.

Drowning Pattern

Numerator is declining, Denominator is declining, resulting in a declining ratio line

This is the flying pattern of underperformance. This strong underperformance pattern shows that the overall market is bearish, but the numerator is more bearish therefore resulting in a declining ratio line. These stocks can be used to take a short position in a bearish market environment.

Cat Pattern

Numerator is declining, Denominator is rising, ratio line is declining

This pattern shows strong underperformance as well. Although the market environment is bullish, the stock’s price is still declining therefore showing weakness. Before concluding this as a strong underperformance, we must confirm whether the denominator is in an uptrend or is having a short-term pullback. It could also be possible that the stock is in a strong uptrend and is currently in a pullback.

Bearish star Pattern

Numerator is rising, Denominator is rising, ratio line is declining

This pattern is just like the bullish star pattern. The overall market environment is bullish, but the returns generated by the stock is lesser than that of the market. This means some other stock is performing better. These can be used as a bearish reversal pattern if the market environment is to change from bullish to bearish.

This is one of the most important newsletters in this series on Relative strength. Although lengthy, this newsletter is important to understand the nature of performance on Ratio charts and to understand the types of stocks to participate in based on Relative strength pattern. In the coming newsletters, we will explore other tools to understand relative better.

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.

👇🏻👇🏻👇🏻