Momentum investors will often look to Relative Strength for clues to help with security selection. This article will explore the topic in greater detail, pointing out some misconceptions as well as applications.
What is Relative Strength?
Relative Strength (RS) is the measure of how strong a security’s price trend is compared to that of another security. In most cases, RS is used to gauge which securities are the strongest (or the weakest) compared to the overall market, with the S&P 500 being a favorite reference point for many.
For example, a stock or ETF which is greatly outperforming the S&P 500 would be said to have high RS, whereas any security that happens to be greatly underperforming the broad market would be deemed to have low RS.
At its core, Relative Strength falls under the momentum investing discipline. This means that Relative Strength seekers aim to buy high and sell higher.
Read more about Momentum Investing.
What Relative Strength is Not
Relative Strength should not be confused with the Relative Strength Index (RSI). The latter is a technical momentum indicator, or more specifically an oscillator, which compares recent gains versus recent losses in an effort to determine oversold and overbought conditions. RS, on the other hand, is only concerned with gains and losses compared to the market and not to the individual security’s price history like the RSI.
The Basics behind a Relative Strength Strategy
There are a multitude of ways to utilize RS when assembling a strategy, but the basics boil down to using this measure to start your security selection process.
Here is an example of how you might use this type of analysis:
- Suppose you want to put capital to work. Wait for a pullback in the broad market. There is no concrete definition of what that means quantitatively, but a sell-off of more than 2% and less than 10% is generally a good range for the S&P 500.
- During the pullback observe which securities are not falling as much as the major average, or better yet are rising. These securities – the ones with high RS – are likely to outperform once the averages settle down and bullish momentum returns to the broad market.
- This list of securities can be used in many ways. For example, if you notice a lot of biotech stocks rallying in the face of a sell-off, you could play the expected continuation of this trend with an industry ETF to avoid the troubles (and the risk) of choosing a single biotech stock.
Learn more about simple momentum trading strategies.
Consider the following resources for RS metrics:
Risks to Relative Strength
No trend lasts forever
Perhaps the biggest risk to relying on RS measures is the outright risk of an unexpected trend reversal. There is always the potential for an exogenous factor or surprise event of some sort to completely change the direction of price trends already in place.
RS can be Misleading
If a “regular” market pullback turns into a full-blown correction, or even worse a bear market, then even those securities with the highest RS measures are vulnerable to swift profit-taking pressures. Just like a rising tide is said to lift all boats, a bear market can (and will sooner or later) bring down even “best of breed” names.
Ways to Play
Aside from implementing your own RS strategy, there are a number of ways to tap into this investment approach via ETFs. Currently, there are two issuers that have funds focused exclusively around RS-themed methodologies: PowerShares and FirstTrust.
Some of the most well-known ETFs based on the principles of RS include the PowerShares DWA Momentum Portfolio ETF (PDP) and First Trust’s Dorsey Wright Focus 5 ETF (FV).
The Bottom Line
Relative Strength can be a very insightful metric when it comes to security selection, and especially so after a market-wide pullback as discussed in the strategy section above. As with any other investment strategy however, it is paramount to really research it in-depth so you may uncover its nuances and drawbacks to better determine if it is right for you.
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