What is Relative Strength and how to use it to generate trade ideas?
How do you find high-performing assets in all market conditions? Enter Relative Strength. This is a metric that helps you identify leaders within any market (E.g. say, US Stock Market). Identifying momentum stocks using Relative Strength can help you find emerging opportunities in any market conditions.
What is momentum trading?
Momentum trading also called trend following is the idea of getting in and out of trades as the trend keeps rising or falling. You buy where prices are rising and sell the ones that are falling in price. This strategy aims to capture some of the upside movement by buying an asset when it is rising high and selling it even higher. Momentum strategies work well for short-term trading but can be very risky for long-term investing because they require constant monitoring, frequent trading, high commissions, and taxes which incur costs over time.
On the short-term trading horizon, momentum has shown to offer a good reward potential at low risk.
Relative strength (RS) is one of the metrics used in a momentum trading strategy.
Relative strength helps identify assets with a strong positive price momentum compared to their peers.
Mathematically relative strength is the equivalent of the percentile rank of an asset, say a stock, based on the performance/return in a given time period in relation to other stocks in the market. In other words, it shows what percentage of stocks have a given stock outperformed in the selected time period.
Example: A relative strength of 90 in a 1-year period for a stock X means that the stock X outperformed 90% of the other stocks in the past 1-year period.
Relative strength is one way to get good results while keeping your risk on the low side.
Note: Relative strength shouldn’t be confused with the Relative Strength Indicator (RSI). The latter is a momentum indicator that measures the magnitude of recent price changes of an asset used particularly to analyze if it is overbought or oversold.
Relative strength can help you identify market leaders.
You can identify market leaders in any given time frame by sorting descending on the Relative Strength (RS) value and filtering out those that are below a particular RS value. Typically, RS values of 90–95 and above help identify strong leaders.
Sometimes you would want to use Relative Strength to find leaders within a market cap, sector, or industry group. This is just another way of looking at relative strength in a more granular context. In this case, though, you are looking for companies that have outperformed their peers within their respective categories. For example, you might be interested in finding out which energy stocks have generated the strongest returns over the past three months (or any time period) relative to their peers in the same industry. This can help you identify companies that may be ready for a breakout move, after short pullbacks, if they continue this trend of outperformance against their peers and/or competitors moving forward.
Also, it is important to find the leaders within the groups that have high performance as a group compared to other groups. For example, say the oil and gas industry is outperforming all other industry groups then looking for market leaders within the oil and gas industry and finding the right entry points is likely to have a high potential reward at lower risk.
Another angle of leveraging relative strength is that instead of looking at an RS value at a fixed point in time, it is often useful to look for those assets where the RS value has been trending up. That can identify momentum gainers and potential future leaders, early on.
Not a magic bullet.
Relative Strength is a great way to scan for trade ideas. However, like any single metric in the world of trading, it is not a magic bullet. It should be used as one of several criteria to form the hypothesis to generate and validate trade ideas. The best trade ideas are the ones that triangulate an opportunity from different data points. Each matching criterion helps add confidence to the decision process. Correspondingly a set of confirmed criteria, relevant to the hypothesis, can increase the probability of a positive outcome.
Another point of caution when trading with RS is to look for early signs of buying exhaustion as that could mean the momentum may be coming to an end and a potential reversal is due. The RSI indicator can be useful in this context to identify overbought conditions. While the price action and volume carry a lot of information at the individual asset level but it is also prudent to analyze the market or the group breadth as well. This means how many other members in the same group (market cap, sector, industry) are continuing their momentum and if there are any signs of reversals or weakness in any of them. Often looking at the negatively correlated asset classes also provides additional insights into any potential signs of an upcoming reversal.
Using Researchfin.ai to generate RS-based ideas and identify market leaders.
Researchfin.ai is a novel AI-based Financial Market Intelligence platform aimed to help new traders master the craft and become experts in the fastest way.
It provides a very simple natural language search-based interface to form and validate different hypotheses.
Researchfin.ai is currently available only on an invite-only/referral-only basis. But you can request an invite by visiting https://www.researchfin.ai