What is Relative Strength
Relative strength is a momentum investing technique that compares the performance of a stock, exchange-traded fund (ETF) or mutual fund to that of the overall market. By using specific calculations, investors can identify the strongest performers compared to the overall market, creating recommendations for investments. When used as part of the aforementioned investment strategy, relative strength assumes a stock whose price has been rising will continue its upward trajectory.
BREAKING DOWN Relative Strength
Relative strength creates a point of comparison regarding the performance of a particular security against the performance of a selected benchmark, such as a market index, as well as to other similar securities. Relative strength investing has both an entry and exit strategy; investors using this technique aim to buy securities exhibiting signs of strength while selling their holdings as soon as the associated securities begin to appear weak. An investing technique in its own right, relative strength can also be applied to more complex strategies, such as pairs trading.
Using Relative Strength to Guide Investment Decisions
Investors can use relative strength to identify the top performers within a selected group of potential investments. This allows the performance of each security to be directly compared to another or to a selected benchmark index, such as the S&P 500 Index. Traditionally, investors use relative strength to compare stocks to each other or to an index. Investors only use relative strength to compare mutual funds to each other based on their associated net asset value (NAV) divided by the number of shares.
Relative strength analysis is at its best in markets that have strong trends or themes that it can identify or indicate when is the best time to invest in them. It may be less useful in choppier markets where few distinctive themes arise. Further, investors can apply relative strength trading to more than stocks and mutual funds, but also asset classes, ETFs, fixed income, commodities, sectors and other areas of the market. Getting even more specific, it can alert investors to the best investments within an individual class, such as whether they should choose small over large caps within strongly performing equities. Relative strength differs wildly from value investing. Whereas value investing seeks stocks that have underperformed in the past in hopes they will outperform in the future, relative strength zeroes in on the outperformers and rides the wave of their momentum.
Calculating Relative Strength
There is more than one way to calculate an investment's relative strength. One method is to rank all investments within the same investment universe, such as tech stocks or mutual funds, and purchase the top performers.
Another is to take the rate of change in a stock’s price, recorded over a specified period of time, and divide it by the rate of change in a relevant index over the same time period. The stock’s rate of change is divided by the benchmark's rate of change to get a relative strength value. If the value is greater than one, the investment is relatively strong; if the value is less than one, the investment is relatively weak.
For mutual funds, the rate of change within the NAV of a specified fund is calculated over a specified time period and compared to that of other mutual funds. For example, if a fund has a current NAV of $110, up from a previous six-month NAV of $100, the rate of change is 10%. If a second mutual fund has a current NAV of $92, up from a previous six-month NAV of $80, the rate of change is 15%. By comparing the two rates, the second mutual fund would be seen as having a higher relative strength when compared to the first.
Relative strength, as a performance indicator, does not take into account the risk associated with a particular investment.