Stock markets are complicated systems that have thousands of traders. There are many people who buy and sell stocks at any one time. They may have opposing views. To help stock market participants make informed decisions, a variety of charts, ratios and metrics have been created. To make the most of technical tools, it is important to understand the larger context. A relative strength comparison is a method used to determine if a stock or security is undervalued or overvalued in relation to other securities, sectors or benchmarks.
The component of the value investing strategy can include relative strength comparison. Comparative relative strength is a different type of investing. Value investing focuses on finding stocks that are intrinsically undervalued, and then selling them at a higher value. Comparative relative strength seeks out stocks that can be sold at a higher valuation. For relative strength comparison to work, investors assume that the trend will continue. Investors may lose their gains if the trend changes suddenly.
Because it relies on the continuation and growth of a dominant strength, relative strength comparison can be especially useful during prolonged periods of market stability. Comparative relative strength can lose its effectiveness in the face of abrupt disruptions such as the 2008 Global Financial Crisis. Although relative strength comparison is primarily used by stock exchange investors it can also be used to compare other asset classes.
Relative strength, as the name implies, tells you how strong a security is in comparison to other security or indexes. This is represented as a ratio. You can easily calculate the relative strength by simply dividing the base security's price by the comparative security. You would like to know the relative strength for a stock XYZ. You will need to divide the current price of XYZ by the BSE Sensex in order to calculate the relative strength. The comparative relative strength indicator for XYZ will be calculated using the Sensex denominator. You can modify the usage and use sectoral indices or other securities.
Depending on the denominator used, there are many types of relative security strength. Portfolio managers generally consider the relative strength of a stock in relation to the benchmark. The relative strength comparison can be made with another security in a denominator. This is usually done with two stocks from the same sector. It shows the stock's relative strength in relation to its peers. The relative strength comparison between two stocks is only effective if there's a strong historical correlation. Let's say that there are two telecom stocks, XYZ or ABC. The relative strength of XYZ can be calculated by multiplying the price of XYZ with the ABC. The current market price for XYZ is Rs 100. While the ABC price is Rs 500. The relative strength for XYZ stands at 0.2.
Value gains only occur when historical levels are considered. If the historical relative strength is between 0.5-1, then it is obvious that XYZ has been undervalued. A price increase (XYZ), decrease (ABC), or simultaneous increase in numerator, decrease in denominator will bring the comparative relative strength indicator back to historical levels.
Although it is easy to calculate the relative strength, it is essential that you understand the terminology. The type of indicator used to interpret the comparative relative strength indicator will vary. Investors should look for stocks with relative strength when comparing a benchmark index to determine relative strength. Pairs trading, i.e. Pairs trading is when a stock's relative strength is calculated against its peers. For example, the ABC and XYZ examples above show that traders can choose to take long or short positions depending upon the prevailing price. Investors can choose to take long positions in XYZ or short positions in ABC if the relative strength of XYZ falls below its historical levels. When used in conjunction with other tools or trends, relative strength comparison can prove to be an efficient technique.