In this series on learning Relative Strength, we’ve covered several key concepts that serve as the foundation for understanding this topic. We explored the meaning of Relative Strength, the nature of outperformance and underperformance of the numerator, decoding Relative Strength from the perspective of Numerator and Denominator, and using Ratio charts to identify various patterns of Relative Strength. These foundational ideas are essential for grasping the more advanced concepts to come. A clear understanding of these basics is vital for mastering the finer details of Relative Strength. Additionally, we learned about the first tool based on Relative strength called the Ratio Trend Matrix.

In today’s edition, we will learn to analyze the Ratio chart. We will build an understanding of what ratio chart is, then see how to use concepts of price chart analysis on ratio charts and then explore the usage of traditional indicators for Relative strength analysis.

Ratio charts: Plotting and Interpretation

In the previous newsletter on relative strength patterns, we explored the concept of ratio charts. The primary purpose of plotting a ratio chart is to simplify the visualization of relative strength. A ratio chart is essentially a line chart, where each data point represents the ratio obtained by comparing the performance of the numerator to the denominator. We saw in the last newsletter that when the performance of the numerator is better than the denominator, the ratio increases, and consequently the line chart rises thereby indicating outperformance. The same logic goes for underperformance and consolidation.

Below is an example of BAJAJ AUTO. The image shows Nifty 50 price chart, BAJAJ AUTO price chart and the resulting Ratio chart. Although both the price charts were falling, the ratio chart was also falling, indicating underperformance and that the numerator (BAJAJ AUTO) was falling more.

Ratio charts are a highly effective yet often underutilized tool that simplifies relative analysis. For instance, if both the numerator and denominator are in an uptrend, but the ratio line is declining, this indicates that while the numerator is rising, it is not outperforming the denominator and is therefore underperforming. Such insights can be quickly discerned by simply observing the charts.

One of the tricks of Relative strength is as follows:

Outperformance is followed by more Outperformance, Underperformance, or Consolidation.

Underperformance is followed by more Underperformance, Outperformance, or Consolidation.

Consolidation is either followed by Outperformance or Underperformance.

Keeping this in mind will make Ratio chart analysis simpler. Ratio charts, at their core, are simply charts. The fundamental principle of technical analysis involves studying charts using patterns and indicators to anticipate future price movements. This same approach can be applied to ratio charts. However, instead of forecasting price movements, ratio charts are used to assess the relative strength of the numerator. While the method of analysis remains consistent, the focus of interpretation shifts from price to strength.

Analyzing Ratio charts

Ratio charts can be analyzed in the same way as price charts. Patterns commonly observed in price charts, such as triangles, rectangles, head and shoulders, cup and handle, price structures, swing breakouts, and double or triple bottom (top) patterns can also be identified on ratio charts. These patterns convey the same message as they do on price charts—indicating a potential breakout. For example, in the context of ratio charts, a rectangle breakout signifies that a period of consolidation will be followed by a shift in relative performance, either towards outperformance or underperformance (as per the direction of the breakout).

Here are few more ways to analyze the price charts:

1. The price chart and the ratio chart should ideally be in the trend of the price chart.

2. If the price chart is rising or falling and the ratio chart is flat, then the performance of the numerator is with par with the denominator.

3. If both, the price chart and the ratio chart, are giving a breakout around the same time, then these are the candidates to focus on.

4. If there is a breakout on the price chart but not on the ratio chart, then we can look at other candidates.

In this manner, ratio charts can be utilized to filter and confirm breakouts and trends observed in price charts, aiding in the selection of stocks that exhibit strength or weakness. These price charts can then be further analyzed to align with the trader’s specific trading system for decision-making and execution.

Analyzing ratio charts with traditional indicators

Ratio charts can be analyzed using traditional indicators as well. In this series, we will understand usage of Moving averages and RSI in ratio chart analysis.

Moving Averages, particularly the Exponential Moving Average (EMA), are valuable for analyzing the trend of a ratio chart. When the ratio chart is trading above the EMA, it indicates outperformance. Conversely, if the ratio chart is trading below the EMA, it signifies underperformance. If the EMA is moving sideways and the ratio chart hovers around it, the performance of the numerator is on par with the denominator. Moreover, EMA analysis is instrumental in developing trade setups and creating scanners to filter stocks effectively using ratio charts.

The Exponential Moving Average (EMA) can also be employed to identify stocks displaying specific relative strength patterns. For instance, consider scanning for stocks exhibiting the "Lion pattern," characterized by the numerator rising, the denominator falling, and the ratio line trending upward. EMA can be used to create a scanner for this pattern by applying the following conditions: the numerator’s price chart is trading above the EMA, the denominator’s price chart is trading below the EMA, and the ratio line is above its EMA. This approach enables the identification of stocks that exhibit distinct relative strength patterns efficiently.

Observe the chart below of ANATRAJ. The Nifty 50 index moved below 50-EMA in Oct-2024. At the same time, the stock however has been trading above the 50-EMA. Observe that the ratio chart line is trading above 50-EMA as well. This is an example of using EMA line to scan for Relative strength patterns.

The Relative Strength Index (RSI) is a widely used indicator for analyzing the momentum of price movements. However, it can also be applied to ratio charts to assess the momentum of the relative strength displayed by the numerator. While the concept of RSI range shifts remains applicable, the interpretations need to be adapted to reflect the context of relative strength rather than absolute price movements.

Ratio charts are an excellent tool for relative strength analysis, particularly for filtering stocks. However, effectively trading those stocks—understanding key patterns, selecting the right indicators, and interpreting them accurately—requires a strong foundation. This is where TNT One truly makes a difference. Designed as a comprehensive and structured learning path, it guides traders from foundational concepts to advanced techniques. If you are looking to elevate your trading skills and enhance your understanding, TNT One is worth exploring. To know more, click on the poster below.

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