Relative strength is a measurement used by day-traders to evaluate the performance of a stock. It tells a trader how a stock's price trend compares to trends in the market, an index, or a stock.
Learn what a stock's relative strength is, how to calculate it, and how to use it when trading.
What Is Relative Strength?
A stock's relative strength is its price change, as a percentage, compared to another stock's price change. Using simple math, a trader can view which of two stocks is performing better. It is not a trading indicator but a tool used to help evaluate a stock's performance.
Alternate name: Relative Price Strength
How Do You Calculate Relative Strength?
A stock's trend price is the percent change in price over a period of time. For the formula to be an effective measurement, the period of both elements must be the same, such as one day or one year.
Stock trend price is the percent of change in the stock's price over a period; market price trend is percent change of the total market, an index, an industry or sector over the same period.
Relative strength is calculated by using this formula to compare a stock's price change to a change in market or index prices:
To calculate the relative strength of one stock to another, where N is the first stock and N2 is the stock you're comparing it to:
How Does Relative Strength Work?
A relative price strength of 1.0 reveals that the stocks (or one stock and the market) are performing similarly. If the result is greater than 1.0, the stock you're comparing is outperforming the one you're using as a benchmark. If the result is less than 1.0, it is comparatively underperforming.
For example, consider two oil stocks. Suppose they are both experiencing a rally, but one is up by 2% today, while the other is only up by 1%. Using the formula, 2% divided by 1% is 2.0. The stock with a 2% trend is outperforming the one with a 1% trend.
This formula works with any similar investment types. If the EUR/USD is up by 1% today, and the GBP/USD is up by 0.5%, then the EUR is relatively stronger than the GBP (1 ÷ .5 = 2).
Relative weakness works the same way. Suppose the Financial Select Sector SPDR Fund (XLF) is down by 3%, while the Energy Select Sector SPDR Fund (XLE) is down by only 1%. XLF would be relatively weak as compared to XLE. In this case, the security with less change is stronger.
To calculate the relative strength of a stock, divide the stock's trend price by the trending price of an index or a comparative stock.
Limitations of Relative Strength
Using relative strength is not a strategy in and of itself. It is a tool to help you find good trade candidates for your tested and established trading strategy. You can focus on buying relatively strong stocks, and selling or shorting relatively weak stocks, with your strategy.
For example, when major market indexes are moving up, it can be advantageous to trade in sectors and stocks showing more significant gains. When the market indexes are moving down, you might want to be trading in the sectors and stocks that are showing more significant losses.
The limitations present themselves when you're trading in one direction, and the market suddenly reverses on you. You'll need to be prepared for the occurrence and implement your strategy to respond to fluctuations.
What It Means for Individual Investors
There are a few basic guidelines for day trading using relative strength or weakness:
- Short the weakest stocks, and go long on the strongest.
- Establish entry and exit criteria; relative strength is about strong movement and trends, and you don't want to exceed your limits.
Shorting a weak stock involves borrowing it from a broker and selling it, hoping that that the price will fall even more so you can repurchase it at a lower price. Going long involves purchasing a stock and holding it to sell it at a higher price.
Trading with relative strength requires a strategy. Don't randomly buy a strong stock. You still need to follow a trading plan that defines how and where you will enter, how you will control risk, your position size, and how you will exit. Relative strength gives you an idea of good assets to use in your trades.
- Relative strength is comparing two investments, or one investment and a benchmark.
- The tool compares trending price changes to each other.
- Relative strength is a tool used to evaluate stocks, not an indicator to buy or sell one.
- Your trading strategy should include evaluating a stock's relative strength along with other trading tools.