Whether you have a $1,000 or you manage billions, the relative strength (RS) technique is a popular and useful tool for comparing one investment against the overall market. But few individuals ever manage to use the technique effectively, because they fail to incorporate RS into a comprehensive trading strategy. In this article, we define relative strength, explain why it works and demonstrate how individual investors can employ RS strategies. This versatile tool can be applied to stocks, exchange traded funds (ETFs) or mutual funds.

Relative Strength
The goal of investing is to sell something at a price that's higher than what the investor paid to buy it. The problem investors face is determining when prices are low enough to indicate a buy and high enough to decide that selling is the best choice. Relative strength addresses this problem by quantifying how a stock is performing compared to other stocks. The idea is to buy the strongest stocks (as measured against the performance of the overall market), hold these stocks while capital gains accumulate, and sell them when their performance deteriorates to the point where they are among the weakest performers. (For more, see What is relative strength?)

Relative strength has long been known as a valuable investment tool. Jesse Livermore, in Edwin Lefebvre's 1923 classic "Reminiscences of a Stock Operator", noted that "[Prices] are never too high to begin buying or too low to begin selling." In other words, stocks showing high relative strength are likely to continue increasing in price, and it is better, from Livermore's perspective, to buy those stocks than to buy stocks with falling prices. Since the time that Lefebvre wrote, there have been many discussions on the best way to calculate precisely when prices are high, on a relative basis, and when they are low. (Read more about this investing legend, in Greatest Investors: Jesse L. Livermore.)

One of the first quantitative calculations of relative strength appears in H. M. Gartley's "Relative Velocity Statistics: Their Application in Portfolio Analysis", published in the April 1945 issue of the Financial Analysts Journal. To calculate velocity statistics, Gartley wrote:

"First it is necessary to select some average or index to represent the broad market, such as the Standard & Poor's 90-stock Index, the Dow-Jones 65-stock Composite, or a more comprehensive measure … The next step is to compute the comparable percentage advance or decline of the individual stock in the swing … And finally, the percentage rise or decline in the individual stock is divided by the corresponding move in the base index and multiplied by 100, to give the "velocity rating" of the stock."

Velocity ratings are very similar to what we now call beta, the Nobel Memorial Prize-winning idea defined by William Sharpe. These steps also define the basic idea behind relative strength, which is to mathematically compare an individual stock's performance to that of the market. There are a number of ways to calculate relative strength, but all end up measuring a stock's momentum and comparing that value to the overall market. (For more insight, read Beta: Know The Risk.)

After Gartley, it would be more than 20 years until another study on relative strength was published. In 1967, Robert Levy published a very detailed paper, which conclusively demonstrated that relative strength works (or at least that it did during his test period of 1960-1965). He examined relative strength over various time frames and then studied the future performance of stocks and found that those that had performed well over the previous 26 weeks tended to also do well in the subsequent 26-week period.

Applying RS
As an example of calculating relative strength, we can take the six-month rate of change in a stock's price and divide that by the six-month rate of change of a stock market index. If IBM has gone up by 12% over the past six months while the market, as measured by the S&P 500, has gone up by 10%, we would get a value of 1.2. An example of this type of chart is shown in Figure 1.

Figure 1: A monthly chart of IBM with its six-month relative strength shown in the bottom portion.
Source: TradeNavigator.com

As shown in Figure 1, buying and selling based solely on RS trendline breaks would have proven to be a profitable long-term strategy. Buy signals are shown as up-pointing arrows, sells are pointing down.

A monthly chart is shown because RS is best applied over a weekly to monthly time frame to avoid being whipsawed. In this example, buys are made when RS breaks a downward sloping trendline and sell signals occur when a subsequent upward sloping trendline is broken. This technique would have required only three buys over the 15-year period, all profitable. (For related reading, see Momentum and the Relative Strength Index.)

A more common application of RS is to rank order all stocks within an investment universe.

The first step in any ranking process is to calculate a value for RS. While the simple rate of change calculation works well, some investors prefer to use an average of the rate of change over multiple time frames, beta or alpha, which is a concept related to beta. The method used is not as important as consistently applying the formula. Rankings need to be done weekly to maximize gains and, just as importantly, to minimize losses.

Profiting From RS
The idea of ranking stocks by RS can help small investors to manage their retirement accounts. Many employers offer their employees a retirement plan as a part of a total compensation package. Many self-employed persons also maintain retirement plans because of the tax benefits and because they are an important part of an individual's overall financial planning. While traditional pension plans paid employees a percentage of their annual earnings after their retirement, rising costs forced employers to shift the burden of funding retirement to employees, resulting in the defined contribution plans currently offered at most companies.

Under a defined-contribution plan, employees contribute a portion of their total pay toward an IRA. The employer may match part of the contribution. The total contributions are invested, often in the stock market, and the returns on the investment, which ultimately may be gains or losses, are credited to the individual's account. Upon retirement, the balance in this account provides retirement income. (For more insight, see the Introductory Tour Through Retirement Plans.)

Most of these self-directed retirement plans include tax advantages. In exchange for the tax benefits, the government defines strict limits on withdrawals from retirement accounts before you reach retirement age. This makes retirement accounts truly long-term investments and means they should be managed as such. Long-term management makes these accounts the perfect vehicle to apply a relative strength strategy, seeking market-beating gains while being able to accept risk.

If we assume that the employer offers a typical range of investment options, there might be a dozen different mutual funds available. To actively manage this account, the investor can calculate the six-month simple rate of change for each investment option along with a market index each week. The RS trader would invest all of the money in the account in the fund with the highest value.

The decision on when to sell and buy something else can also be based on RS. To avoid whipsaws, you could hold the fund while it is ranked as No.1, 2 or 3. If it falls to No.4 or below in a given week, it should be sold and the currently ranked No.1 fund purchased with the proceeds. When more than 12 funds are used in the calculation, the cutoff rank can be set at 25-50% of the number of investment options.

Conclusion
Test results from studies such as the one conducted by Robert Levy illustrate the benefits of relative strength and prove that this method is worth exploring. The ability to use a relative strength strategy within a retirement account makes this strategy even more accessible to the average investor and it can be used by anyone looking to take an active role in managing their investments.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  2. Mutual Funds & ETFs

    ETF Analysis: Guggenheim BulletShrs 2018 HY CorpBd

    Find out about the Guggenheim BulletShares 2018 High Yield Corporate Bond ETF, and get information about this ETF that focuses on high-yield corporate bonds.
  3. Mutual Funds & ETFs

    ETF Analysis: PowerShares DWA SmallCap Momentum

    Find out about the PowerShares DWA SmallCap Momentum Portfolio ETF, and explore detailed analysis the fund's characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: WisdomTree Bloomberg US Dllr Bullish

    Explore an analysis of information on the WisdomTree Bloomberg U.S. Dollar Bullish Fund, a currency ETF that tracks the overall performance of the U.S. dollar.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: Vanguard Total World Stock

    Learn about the Vanguard Total World Stock exchange-traded fund, which invests in stocks located in numerous countries with a high level of diversification.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  9. Mutual Funds & ETFs

    ETF Analysis: BioShares Biotechnology Products

    Learn more about the BioShares Biotechnology Products fund, an exchange-traded fund that is focused on producers of FDA-approved drugs.
  10. Mutual Funds & ETFs

    ETF Analysis: SPDR EURO STOXX 50

    Learn about FEZ, the Euro Stoxx 50 ETF. FEZ tracks the 50 largest companies in Europe, making it the Dow Jones Industrial Average of Europe.
RELATED TERMS
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Security

    A financial instrument that represents an ownership position ...
  3. Series 6

    A securities license entitling the holder to register as a limited ...
  4. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  5. Board Of Directors - B Of D

    A group of individuals that are elected as, or elected to act ...
  6. Strike Width

    The difference between the strike price of an option and the ...
RELATED FAQS
  1. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  2. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  3. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  4. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  5. Is there a situation in which wash trading is legal?

    Wash trading, the intentional practice of manipulating a stock's activity level to deceive other investors, is not a legal ... Read Full Answer >>
  6. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!