While trading stocks traders often have a problem as to which stocks to choose in an index or sector to trade. It often happens to traders that one sector of the market is moving up but within that sector a trader may get into wrong stocks which underperform the sector. So it is very important to get into the right stocks within the index or sector in order to outperform the market.
Relative strength analysis is an important tool which helps traders and investors to get into the stocks which most probably will perform the best within a sector or index. If a trader is bullish on the Transportation Index, then relative strength analysis helps a trader in choosing the right stocks within the Transportation Index.
Relative strength is defined as the measuring of one market against another over a specific period of time. Relative strength is an important concept in any bull or bear market. After all, if you've found the bull markets why not find the leaders? If an index is in a bear market you can pick stocks which are showing strength even when the overall market is declining.
Not to be confused with the Relative Strength Indicator (RSI), relative strength analysis is simply dividing one market element by another. If this number is increasing, the one you divided it into is stronger; if this number is decreasing, the one you divided by is stronger. You can use this to compare a market sector to the economy in general, or you can pick a company and compare it to the sector’s performance.
The above charts show the comparison between the Dow Jones Industrial Average and Intel. We can easily see through this comparison that while the Dow has risen by almost 10% over the last one year, Intel stock has underperformed the index and has actually dropped 12% during the same period. Thus we can say the Intel stock is underperforming the Dow. An investor who is bullish on the Dow obviously will avoid Intel and will look at other Dow components. Let’s take a look at another chart.
The above chart shows relative strength comparison between the Dow Jones Industrial Average and JP Morgan. While the Dow is up around 10% during the past year, JP Morgan has surged over 36%. An investor who is bullish on the Dow would have JPM in his portfolio and he would have been able to outperform the market.
Relative Strength Analysis also helps investors in identifying the best performing sectors within the overall market.
The above chart compares the Dow Jones Industrial Average with the Dow Jones Biotechnology index in Blue, Dow Jones Utilities index in Purple, Dow Jones Oil and Gas Index in Green and the Dow Jones Home Construction Index in White. The chart tell us at one glance that during the past one year the Dow Jones Construction Index has hugely outperformed the overall market , while the Dow is up 10% , the Dow Jones Construction Index is up over 96% during the same period , the Dow Jones Biotechnology index is the next outperformer and has jumped over 50% . The Dow Jones Utilities index has underperformed the Dow, while the Dow Jones Oil and gas index has registered a slightly lower growth compared to the Dow.
How can you use this Relative Strength analysis in your trading? Depending whether you are going to trade on indices or on individual stocks, you can start at the highest level, comparing a sector index to the overall markets, as represented by the Dow Jones Industrial Average, S&P 500, Transportation Index, or whatever seems most appropriate. You can then see how the sector is performing, even applying simple tools like trend lines and moving averages to help you spot important changes in the trend.
With this information, you can see which market sectors are outperforming or underperforming the overall markets. If you plan to take a long position, it would be better to be in a well performing sector. You could stop there, choosing a composite index or exchange traded fund and trading on the uptrend. The idea would be to invest in the sectors that are turning up, and to move out of the market sectors where the relative strength lines are turning down.
Drilling down further, you could then compare the sector you have chosen to invest with individual stocks in that sector and you can then find the best performing stocks within that sector. By doing this, it’s easy to see which stocks have the greatest relative strength. These are exhibiting a strong uptrend, by being the strongest performers within a strongly performing sector, and therefore they are prime candidates for a trend following trading plan. Another way to use this information is to go for a cheaper stock where the relative strength index is just turning up, in anticipation that it will continue to improve. You should avoid stocks where the relative strength is going down.
This procedure is called a top-down approach to the markets. You start at the very top, looking at the overall market, and you work your way down to individual stocks, so that you pick the best stocks in the best sectors. It’s a tried and tested way of being sure you are on the right side of the market.
Using Relative Strength analysis, a trader an overcome his confusion about which stocks to get into. A simple Relative Strength analysis can help him to get into the right stocks at the right time.
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