It’s All Relative
In his day, Einstein made a revolutionary breakthrough in physics with his theory of relativity. It presented a new way of thinking, answering many questions the Newtonian Physics couldn’t. Albert’s witty quote below personifies the importance of thinking relatively. Relative strength in trading terms does just that—adds another dimension of insight to the price alone.
Relative strength makes a comparison between two financial instruments, often by dividing the security of interest by a benchmark. This ratio is a very helpful and objective tool, giving an intuitive visual cue by rising for strength and falling for weakness.
Below is an example using a ratio comparing SPDR Technology Sector ETF (XLK) with the S&P 500 ETF (SPY) as the benchmark. Technology’s outperformance is displayed when the relative strength line is rising. It’s rising because its price is rising faster than the benchmark’s price. Underperformance works the same in reverse.
(Above: the relative strength of XLK has been rising since late 2013)
Technical analysis can be applied to relative strength as well. For example, the relative strength (green) has a 1-year moving average (blue) applied to it, smoothing out the short-term moves and isolating the trend. Support and resistance or trend lines are commonly used as well.
Whales, Sharks And Remoras
Relative strength is a big deal because it’s important to the big market players. Hedge funds and mutual funds—the sharks and whales of finance—are graded on their relative performance to a benchmark, like the S&P 500 Index. Their bonuses depend upon avoiding underperformers and finding outperformers. They are motivated.
Relative strength studies, like ratios and comparing actual returns over a window, answer additional important questions. How can we objectively rank different opportunities? How can we track if one asset class is outperforming another? How can a change in a relationship be detected?
Portfolio managers are searching for the answers to these questions too—with extensive resources. Acting together, as a like-minded group, they have the capital to create and perpetuate trends.
So the question becomes “how can we follow smart money?”. A helpful analogy is the relationship between a remora and a shark or whale.
Einstein Would Have Been A Remora
A slender marine fish, the remora is small, slow and weak as fish go. However, the remora is smart and resourceful in overcoming these shortcomings.
The solution? The remora attaches itself with a sucker to a shark or whale, typically a big one. This innovative tactic yields a free ride, a free meal, and protection.
Einstein would have been a remora. You can be a remora. Follow the smart money.
It would be cumbersome sifting through charts manually, comparing opportunities, looking for the big fish in a big ocean. Remember, Einstein as a remora worked smart. A watchlist, like the one below, can filter and rank opportunities quickly, based on attributes important to you.
In the pictured watch list, I’ve scripted examples of other metrics that could compliment relative strength. For example, I’ve ranked the S&P 500 GICS Sectors by their 3-month rate of change of relative strength (column “RS 3-Mo ROC”). This is how quickly relative strength is changing. Even fundamentals could be added, like the P/E and Yield.
One thing to be aware of with relative strength, is that a financial instrument can simultaneously have outperformance and negative returns. This can be visualized in the chart below. Plotting price and relative strength together on a chart, or adding absolute returns like the 3-month and 1-year returns to a watchlist, make it easy to monitor for this condition.
(Above: price is falling while relative strength is rising.)
Like Einstein and Newtonian Physics
You could take this concept further by creating a group of stocks or a benchmark of your own making. Whatever you’re trying to compare and analyze, you can do it. Explore and break new ground!
On the chart below, I created a custom code with the famed “FANG” stocks: Facebook (FB) + Amazon (AMZN) + Netflix (NFLX) + Google (GOOGL), then plotted price and relative strength to SPY. This was a great way for me to monitor and analyze a group of stocks that were constantly mentioned together in the news.
Swim With The Sharks
Measure relative strength and you’ll be measuring something important to the smart money. Add this dimension to your research and gain further insight. Use it to work smart and cover a larger ocean or to be innovative and create new opportunities.
Carson Dahlberg, CMT
Author & Co-founder of Northington Dahlberg Research
Carson comes to Optuma bringing nearly 20 years of experience in the financial markets involved in technical and quantitative trading, research and education. Carson has worked for several notable firms: Morgan Stanley, Wachovia Securities, Wells Fargo, and Schaeffer’s Investment Research. In addition, he is the co-founder of Northington Dahlberg Research, a quantitative driven, volatility-based research firm, and was the Director of the CMTinstitute (an online program to assist financial professionals in the passing of the CMT examination process).
Carson is presently a Director at Large on the Board of the Market Technicians Association and serves the Market Technicians Association (MTA) in various capacities. He was the founder and first Chapter Chair of the Charlotte Chapter for the MTA. His involvement with being the Committee Chair for the Ethics Committee has led to an updated and globally relevant ethics offering for the designation. In the past, he has served on the Admissions Committee, was the Board Liaison for the Journal of Technical Analysis Committee, and was the Director of the CMTinstitute.
Carson received a degree in Chemistry from the University of Cincinnati and was awarded the Chartered Market Technician designation in January of 2008.