Frequent readers of my newsletter know that I always advice to use Relative strength (RS) for stock selection. Although, I have only mentioned them before and not really discussed how to use it for stock selection. There are various ways to understand the Relative strength of an instrument. Some are scanner based and some are based on manual chart analysis.

In today’s newsletter, we will discuss one of the methods of understanding the relative strength of an instrument using a scanner. First, we will understand the patterns of Relative strength. These patterns are important for understanding the whether the stock is outperforming or underperforming. Then, we will look at a tool on RZone (by Definedge Securities) called Ratio trend matrix. This tool will help us build an understanding of the trend of the relative strength of the stocks within a group of stocks.

I have explained the concept of Relative strength in one of my previous newsletters. If you are new to this concept, I would encourage you to read the following newsletter to understand the concept first.

Patterns of Relative strength (RS)

Price patterns on Price charts give a set of information regarding the demand and supply of an instrument. Similarly, RS patterns give an understanding of the strength and momentum of the instrument. More precisely, they help us understand the degree of outperformance or underperformance of the instrument relative to the denominator.
But, unlike price patterns, the thing about RS patterns are a factor the behavior of the numerator and the behavior of the denominator, both in terms of percentage.

There are 6 basic patterns of RS:
Flying pattern: The denominator is rising but numerator is rising more
Lion pattern: The denominator is falling but the numerator is rising
Bullish star pattern: The denominator is falling, and the numerator is falling but less than the denominator
Bearish star pattern: The denominator is rising, and the numerator is rising but less than the denominator
Cat pattern: The denominator is rising but the numerator is falling
Drowning pattern: The denominator is falling but the numerator is falling more

The numerator is usually a stock and the denominator is usually a broad market index like Nifty 50. This is used in the newsletter although they can be different for the trader.

These patterns are important to understand relative strength and mastering them is crucial. Out of these 6 patterns, Flying, Lion, and Bullish star show outperformance of the numerator; Drowning, Cat, and Bearish star show underperformance of the numerator.

Ratio Trend matrix and RS patterns.

Ratio trend matrix is an interesting tool developed by Definedge securities. This tool uses candlestick charts to understand the RS trend of a stock. The scanner uses the candlestick behavior of the stock and Nifty 50 to plot one of the RS patterns discussed above.

To use the tool, Go to RZone website → Matrix: Price & RS → Ratio trend matrix. Select the group of stocks, the number of bars, the denominator (Scrip 2), and the frequency.

Number of bars refers to the number of candlesticks the trader wants to consider for analysing the trend.
The frequency here refers to the timeframe of each candle. The frequency could be daily, weekly, monthly etc.
20 bars and Daily frequency is use here. This allows the trader to understand the RS of one month.

In the below image, Bar 0 refers to the RS pattern formed by the most recent price behavior of the Scrip (Left most column) and Nifty 50. Bar 1 refers to the RS patterns formed by the price behavior of the Scrip and Nifty 50 one day before the most recent day. Similarly, the Bar n refers to RS pattern formed n days before the most recent day. The Total score calculates how many times the RS pattern formed was bullish in nature. For example, DRREDDY’s total score is 15. This means out of 20 days, the bullish RS pattern formed on 15 days. That is, 75% of the time the scrip was outperforming the Nifty 50 in the period.

Similarly, the total score is assigned to other scrips as well.

How to integrate Ratio trend matrix in trading?

RZone has an option to save the results of a scanner as a group of stocks. After scanning the group, the stocks with a total score of more than 50% of the number of bars can be saved as a group.

Boost strategy and other breakout strategy can be used for participating the stocks. Although, the trades should be identified manually. I believe that the Ratio trend matrix is only good till the step mentioned above. After the group is saved, the trader must analyse each scrip individually to identify opportunities to trade.

I would advise that once the group is saved, start analysing the charts from the bottom of the list. This is because the stocks in the top of the list are already in their outperformance stage. It is better to participate in stocks which are about to start the outperformance. This outperformance will start when the stocks move above the 50% mark of the total score.

This is one of the ways to identify Relative Strength of stocks. I have discussed other popular yet underrated tools in my course Trade Markets Using Relative Strength. The best part about this course is that there is a method of RS for each kind of trader. Do check it out!!!!