A:

Relative strength is a measure of the price trend of a stock or other financial instrument compared to another stock, instrument or industry. It is calculated by taking the price of one asset and dividing it by another.

For example, if the price of Ford shares is $7 and the price of GM shares is $25, the relative strength of Ford to GM is 0.28 ($7/25). This number is given context when it is compared to the previous levels of relative strength. If, for example, the relative strength of Ford to GM ranges between 0.5 and 1 historically, the current level of 0.28 suggests that Ford is undervalued or GM is overvalued, or a mix of both. The reason we know this is because the only way for this ratio to increase back to its normal historical range is for the numerator (number on the top of the ratio, in this case the price of Ford) to increase, or the denominator (number on the bottom of the ratio, in our case the price of GM) to decrease. It should also be noted that the ratio can also increase by combining an upward price move of Ford with a downward price move of GM. For example, if Ford shares rose to $14 and GM shares fell to $20, the relative strength would be 0.7, which is near the middle of the historic trading range.

It is by comparing the relative strengths of two companies that a trading opportunity, known as pairs trading, is realized. Pairs trading is a strategy in which a trader matches long and short positions of two stocks that are perceived to have a strong correlation to each other and are currently trading outside of their historical relative strength range. For example, in the case of the Ford/GM relative strength at 0.28, a pairs trader would enter a long position in Ford and short GM if he or she felt the pair would move back toward its historical range.

For related reading, check out Momentum And The Relative Strength Index.

RELATED FAQS
  1. What is the effect of a reverse split on the stock's value?

    Find out more about reverse stock splits, how to calculate a reverse stock split and how a reverse stock split affects a ... Read Answer >>
  2. How do you calculate a reverse split using Excel?

    Find out about reverse stock splits and how reverse splits affects outstanding shares and share price, and learn how to calculate ... Read Answer >>
  3. How is a put option exercised?

    A put option is a contract that gives the option holder the right, but not obligation, to sell a set amount of shares (1 ... Read Answer >>
  4. Does the buyer or the seller control a call option?

    Buy call options and maintain control over the price you pay and when to buy a given stock. Learn how to maintain control ... Read Answer >>
  5. What business processes were used to establish the Chevrolet motor company?

    William Durant, the founder of General Motors, lost control of his company due to his aggressive expansion plans. Going wholeheartedly ... Read Answer >>
Related Articles
  1. Investing

    Analyzing General Motors Company's Return on Equity

    Understand General Motors' return on equity (ROE) in recent years and what it tells investors about its overall performance relative to its competition.
  2. Investing

    This American Car Maker Has 35% Upside Potential

    <p>In the final showdown of the film Wall Street, Bud Fox reminds his former mentor, Gordon Gekko to "...never get emotional." As an investm...
  3. Investing

    General Motors Stock to Trade Ex-Dividend (GM)

    To the extent GM can execute in the quarters ahead, its stock price -- valued at a trailing P/E of 5 -- might be one of the better bargains in its sector.
  4. Investing

    Ford's March Auto Sales Miss Target (F, GM)

    With the fleet business rising eight percentage points year over year, Ford's sales -- despite how attractive they may appear -- become less valuable.
  5. Investing

    What Drives Ford's Profits? Not Just Cars

    Ford, an experienced legacy car manufacturer, sells a lot of cars around the world and makes a lot of money in the money lending and leasing business.
  6. Investing

    General Motors Stock Drives Higher on Q1 Beat (GM)

    Combined with improved performance in Europe, not only did GM beat earnings expectations, the company affirmed its bullish outlook for the year.
  7. Insights

    Automakers Are Back -- And This American Icon Has 50% Upside

    In the corner offices of the nation's major airlines, industry executives are still beaming about the "great re-rating of 2013."#-ad_banner-#That was when deeply cyclical airline stocks, which ...
  8. Investing

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  9. Managing Wealth

    Henry Ford: Industry Mogul And Industrial Innovator

    This man made his dream of bringing the automobile to the masses a reality.
  10. Investing

    How GM Keeps on Truckin'

    Following a giant bailout and a giant IPO, the new GM is carried by sales of its giant trucks. But is it profitable?
RELATED TERMS
  1. General Motors (GM) Indicator

    An indicator based on the theory that the performance of U.S. ...
  2. Relative Strength

    A momentum investing technique that compares the performance ...
  3. Purchase Price

    The price that an investor pays for a security. This price is ...
  4. Overvalued

    A stock with a current price that is not justified by its earnings ...
  5. Historical Volatility - HV

    The realized volatility of a financial instrument over a given ...
  6. Currency History

    The historical values of a base currency in relation to the values ...
Hot Definitions
  1. Derivative

    A security with a price that is dependent upon or derived from one or more underlying assets.
  2. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  3. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
  4. Death Taxes

    Taxes imposed by the federal and/or state government on someone's estate upon their death. These taxes are levied on the ...
  5. Retained Earnings

    Retained earnings is the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested ...
  6. Demand Elasticity

    In economics, the demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables. ...
Trading Center