TradingMarkets.com
Scanning for Profits, Part I: Using Relative Strength
Wednesday November 26, 3:48 pm ET
By Dave Landry
Your quest for trading profits begins with finding the right stocks to trade. Stocks with a high EPS are a good place to start because earnings, in part, power stock prices. The proof, though, is in the pudding. What stocks are moving right now? To answer that question, you need to look closely at Relative Strength.
Simply stated, Relative Strength (RS) is a measure of a stock's price performance compared to either a market index, such as the S&P 500, or against a universe of stocks. RS quickly tells you whether a stock is outperforming or under performing the overall market.
Displayed as a number from 1-99, a high RS indicates a strong stock; a low RS, a weak stock. A Relative Strength rating of 99 means that a stock outperformed 99% of its peers. By contrast, a Relative Strength of 1 means that the stock performed worse than 99% of the others. A stock with a high RS is usually uptrending (not always, since a stock going sideways will have a high RS if the overall market is going down). Stocks with low RS are downtrending, performing worse than most other stocks. A stock that is down 10% during a period when the market is up 10% is showing poor relative strength.
The Tradingmarkets.com Stock Scanner contains a database of about 5000 stocks. When you perform a scan using this system, you're measuring a stock against this database. Ideally, you want to focus on indices, sectors and stocks that are performing the best, i.e. the ones that have high relative strength.
To give you an idea of what RS looks like, several chart examples will help. Figure 1 (below) is a chart of the S&P 500 Index as of 3/7/01.The index is obviously in a downtrend, trading below the 50- and 200-day moving averages. This is the index used by many as a measure of the overall market.
Figure 1
Compare this with Figure 2, a chart of the Oil Services Index (Philadelphia:^OSX - News), also as of 3/7/01. This index, despite a downtrend beginning early December, is trading in two-month-high territory. Obviously, the OSX is stronger relative to the S&P 500. To say merely, "The market was down" completely misses the boat, There are always sectors and stocks moving, no matter what the overall market is doing.
Figure 2
Figure 3 (below) is a chart of Rowan Companies, Inc. (NYSE:RDC - News) for the same period. Rowan is a member of the Oil Service Sector Index. The six-month RS is 83, which means RDC was stronger than 83% of all other stocks in the Tradingmarkets.com Stock Scanner database for that period. Despite a weak first three months, the price at the end of the six-month period was very close to the price at the beginning of the period, which is why the RS was so high -- the rest of the market was getting slammed. RDC held up well in a down market, and therefore, had good relative strength. In the most recent three-month period, the stock moved up nicely, and the 93 RS reflects this strong move. The stock had better performance for the three-month period than it had for the six-month period.
Figure 3
During the three-month period, RDC showed higher highs and higher lows and good thrusting days followed by tradeable pullbacks -- what a strong stock should have.
Now let's take a look at a weak stock during the same period.
Figure 4 is a chart of Cisco, with a three- and six-month RS of 3. If you like to play the long side, there's not much here for you. Aside from a few rallies, the obvious trend here is down. Any rally that materialized got crushed quickly. If you found a setup that looked good, it was probably doomed from the beginning.
Figure 4
The fact is, bullish patterns found in stocks with low RS tend not to work out as well (if at all) as those found in higher RS stocks. No matter what the pattern looks like, or where the support lies, or what your indicators say, or what (God forbid) the stars say, it's probably not going to work well in a stock with poor RS.
The moral? Focus on stocks with strong RS.
The best is 99, but use at least 85 in your scans. This way you'll only be looking at stocks that have a good shot at reacting well to pattern setups. The three-month relative strength is the more significant and timely number, since it deals with the most recent price performance.
"I like to short," you say. Fine, then focus on stocks with low RS. Be careful of stocks whose RS is too low -- some of these have already completed most of their downward move. For shorting, RS of 20-50 is a good place to start.
One more thing: As market conditions improve, high-RS stocks are more likely to bust out of the gates quicker. Watch them. |
