Relative Strength - An Introduction

You know the patterns. You know the indicators and the RSI levels to look for. But which stock to apply them to? How do you know which stocks to keep in the Portfolio and which ones to remove? There are about 2000+ listed companies on the Indian stock market.

Stock selection if done rightly can give a trader an edge. It is the very first step to building a trading system. The answer to the above questions is answered by using Relative Strength (RS). RS is a concept that may help you as a trader to improve the chances of successful trades.

Relative Strength means assessing the strength, in terms of returns, of an instrument relative to the strength of another instrument. In technical analysis, RS is used to measure the performance of Mutual funds w.r.t its benchmark. But what if the same logic could be used for stocks? In that case, RS can be used to measure the performance of individual stocks w.r.t a market index. An index is used because it represents the whole market or a sector. Nifty 50 is an index usually used in RS.

It is all about performance

RS is a ratio between two instruments. The numerator is being compared to the denominator. Therefore, it is important to be aware of what the numerator is being compared to. The numerator and the denominator can be stocks, index or a commodity. Stock in the numerator and an index in the denominator is used as an example here.

RS gives the information about the performance of a stock in comparison to the index. When compared, the stock can either be outperforming or underperforming the index.

Outperformance means that the performance of the stock is better than the performance of the index. Underperformance means the performance of the stock is worse than the performance of the index. Outperformance or underperformance is based on the timeframe. It can be over days, weeks or even years of out- or underperformance.

Relative Strength can be plotted as line charts, P&F charts, and Renko charts. The concepts of these charts like patterns, support and resistance, trendlines, and moving averages can be used.

“Okay, it’s crucial, but how do I use it?”

RS is mainly used for stock selection. Stocks within an index, such as Nifty 200 or Nifty 500, can be filtered based on outperformance and underperformance w.r.t Nifty 50. Focus on bullish setups in outperforming stocks and focus on bearish setups in underperforming stocks.

This newsletter is just an introduction to a wonderful concept. This concept has patterns that help in further refining the stock selection process. It can also be used for pair trading and portfolio construction.

To understand this concept further, I would suggest you spend a few minutes and watch this video: