What Is Relative Strength?
Definition & Examples of Relative Strength
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 percent price change compared to another stock's change. Using simple math, a trader can view which of two stocks is performing better. It is not a trading indicator but is 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. For the formula to be an effective measurement, the period of both elements must be the same, such as one day or one year.
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 the stock and 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 underperforming.
For example, consider two oil stocks. They are both experiencing a rally, but one is up 2% today, and the other is only up 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 1% today, and GBP/USD is up 0.5%, then the EUR is relatively stronger than the GBP (1 ÷ .5 = 2).
Relative weakness works the same way. If the Financial Select Sector SPDR Fund (XLF) is down 3%, while the Energy Select Sector SPDR Fund (XLE) is only down 1%, then Financials are relatively weak compared to Energy. In this case, the security with the least change is stronger.
To calculate the relative strength of a stock, divide the stock's trend price by the trending price of the market or a comparative stock.
Limitations of Relative Strength
Relative strength is not a strategy in and of itself. It is a tool to help you find good trade candidates for your already tested and established trading strategy. Focus on buying relatively strong stocks and selling/shorting relatively weak stocks with your strategy.
For example, when major market indexes are moving up, you should be trading in sectors and stocks showing the most significant gains. When the market indexes are moving down, you want to be trading in the sectors and stocks that are showing the most significant losses.
The limitations present themselves when you're trading one direction and the market suddenly reverses on you. You'll need to be prepared for the occurence and implement your strategy to deal with fluctuations.
What It Means for Individual Investors
There are a few basic guidelines for day trading using relative strength or weakness:
- You should short the weakest stocks and go long on the strongest.
- You should 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 falls 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/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.