Previously, we have discussed about the concept of Relative Strength (RS). We then saw a RS tool that can be used for understanding the Relative Strength trend of an instrument based on the RS patterns it is forming.

But what if we could plot RS on the price chart in the form of an indicator? What if this indicator could tell us exactly when the stock is starting to outperform the denominator? Today’s newsletter is based on a RS indicator that helps us do just that. This tool is called RS alpha indicator.

Interesting…. But what is RS alpha?

RS alpha indicator is a popular RS tool used by many traders. When we plot RS charts using different charting methods such as Renko, Ratio, or Point and Figure charts, we are essentially dividing the numerator’s price return by the denominator’s price return. But, for calculating RS alpha indicator, we calculate the Rate of change of the denominator over a look back period and deduct this from the Rate of change of the numerator over the same look back period.

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

This value is calculated every day and plotted as a line indicator.

The calculation of the indicator is such that when the indicator is above the zero line, it means the numerator has started to outperform the denominator. When the indicator is below the zero line, it means the numerator has started to underperform the denominator.

Some of the famous look back period is 52 weeks, 50-days, 100-days etc. Personally, I prefer using 60 days as a look back period. This is because 60 days shows the outperformance of a quarter. Therefore, the smallest look back period is 60 days on Daily TF candlestick charts.

Average of the Indicator

A moving average of the RS alpha can also be calculated. This average is as important component of the indicator as much as the RS indicator itself.

The average plays two roles: Crossover and Indicator trend.

When the indicator and average give a bullish crossover and the indicator is above the average level, the outperformance is strong.

When the indicator and the average give a bearish crossover and the indicator is below the average level, the outperformance is weaking.

The average of the indicator should be 50% of the look back period. For example, if the look back period for the indicator is 50 period, then the average should be calculated for 30 days.

Okay…Understood. Let’s trade.

To trade using RS alpha indicator, we need a trend filter. EMA channel has been a recurring trend filter in our newsletters, so the same is used here.

To participate long in an instrument, we need the instrument to be trading above the EMA channel and the RS alpha indicator to be trading above the average and above the zero line. In the following examples, 60 period is used as look back period and Nifty 50 is used as the denominator.

As per my observations, RS Alpha is a great tool to identify false breakouts and to trade breakouts in a chart.

Observe the chart below of KPIL and HEROMOTO. The breakouts are marked in red line. Observe the RS alpha indicator during this time. It is above the average line and above zero line as well.