In today’s installment of our series on relative strength, we will explore a widely used relative strength indicator known as RS Alpha. This indicator simplifies relative strength analysis by representing it as a single line. We will begin by understanding how the indicator is calculated, followed by determining the appropriate look-back period and interpreting its signals. The newsletter will conclude with a few practical examples to illustrate its application.

Relative strength indicator: Calculation

The Relative Strength Indicator is a widely used tool in relative strength analysis, often referred to as the Relative Strength Alpha Indicator (RS Alpha). The term "RS Alpha" highlights its unique calculation method. Traditional relative strength (RS) is typically calculated as the ratio of the performance of two instruments, with the resulting value plotted at the close of each session.

In contrast, the RS Alpha Indicator is derived by calculating the difference between the rate of change of the numerator and the rate of change of the denominator over a predefined look-back period. This value is then plotted at the end of each session. The indicator is commonly displayed below the price chart, providing a visual representation of the strength of the numerator.

RS Alpha = (ROC of Numerator - ROC of Denominator)

Popular look-back periods are 50-day, 100-day and 52-weeks.

In essence, this indicator calculates the Alpha of the numerator during each session. Alpha represents the excess returns achieved by the numerator relative to the benchmark's (denominator's) returns. The indicator's design ensures that when its value is above the zero line, it reflects the outperformance of the numerator, and when it is below the zero line, it signifies underperformance.

For instance, if the numerator’s rate of change (ROC) is 10% and the denominator’s ROC is also 10%, the indicator will plot at zero. If, in the subsequent session, the numerator’s ROC increases to 12% while the denominator’s ROC remains at 10%, the indicator will plot the next point at 2%. As the numerator continues to outperform the denominator, the difference grows, and the line trends upward. Conversely, when the numerator underperforms, the line will decline. Below is an example of the RS Alpha indicator applied to the chart of AJANTPHARM, with the Nifty 50 index used as the denominator.

Look-back period: The important factor

The look-back period used for this indicator is crucial, as it influences how the alpha of the numerator is plotted. From my observations, the look-back periods work best when they are multiples of 60 days on daily timeframe OHLC charts, depending on the trading timeframe. This is because a month typically consists of around 20 active trading days. For swing trades, it is ideal for the numerator to outperform over at least a quarter, or 20 × 3 = 60 days. Similarly, for positional trades, the focus should be on a longer period, such as 120 days, to capture a more significant trend.

Integrating the indicator in the setup

RS Alpha can be used in two ways:

1. As a breakout confirmation

2. For pullback trading

When the stock is in consolidation for a long time, we would want the price chart and the RS Alpha indicator to give a breakout at the same time. Although, it is preferred the RS Alpha is above the zero line before breakout truly happens. On the indicator, this will mean to break above the zero line.

When the Indicator is above the zero line and rising, then any pullback of the numerator towards the EMA can be used as a pullback participation opportunity.

Observe the chart below of BEL and APARINDS. The price was in a consolidation and gave a breakout at the line marked. The RS Alpha indicator was above the zero line before the breakout. Subsequently, the price took pullbacks at many points when the indicator was still above the zero line.

When the indicator is above the zero line, it shows the numerator is outperforming and has a probability that it will continue to outperform.

This indicator serves as a valuable tool for analyzing relative strength with simplicity. One of its key advantages is its ability to divide the strength of the numerator into two parts using the zero line. The plotted line provides insight into the trend of either outperformance or underperformance, making it easier to assess relative strength dynamics. In the upcoming newsletters, we will explore additional tools for relative strength analysis that will assist traders in efficiently scanning stocks and gaining a deeper understanding of the numerator’s strength. So, stay tuned.

If this newsletter has sparked your interest in trading and technical analysis, be sure to check out TNT One. This exclusive membership grants access to a vast library of technical analysis resources that can be studied at your own pace. One of the key benefits of this membership is the weekly live session led by Prof. Kaushik Akiwatkar, where he analyzes the market and demonstrates the practical application of the concepts taught.

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