Relative strength readings are incredibly important in stock selection in all kinds of markets. The relative strength calculation is simply done by dividing the price of the stock by the price of the Dow or any index you choose and then multiplying by 1000. This number can then be plotted on a point and figure chart. RS chart buy signals are given when a column of X's exceeds a previous column of X's. Sell signals are given when a column of O's exceeds a previous column of O's. Relative strength signals generally last about two years and tell the overall trend of a stock. Positive relative strength suggests the stock will outperform the market while negative relative strength suggests the stock will underperform the market. It's also important to watch for reversals for short term guidance.
Say for instance XYZ was at $80 and the Dow was at 2,500. If we divided $80 by 2500 and moved the decimal we would get 32. This number 32 can be plotted just as if it was an $32 stock. Let's say the following week the stock falls to $72 and the Dow dropped to 2000. We now divide $72 by 2000 and get 36. In this case the stock dropped, the Dow dropped but the relative strength chart went up. This tells us that the stock is doing better than the Dow and it is possible that the only reason it is down is that the overall market is down. This stock could be one of the first to snap back when the overall market is ready. Remember according to a University of Chicago Study 75-80% of the risk in a stock is market risk, 20-25% is stock specific risk.
Relative Strength readings are taken daily and plotted on a Point & Figure chart. There three types of relative strength (2 for stocks, one for sectors). A stock can be measured on a relative basis versus the overall market and versus its peer group (other stocks within the same sector). Sector relative strength is a measure of that sector's strength versus the S&P 500.
|Stock RS Reading||Peer RS Reading||Sector RS Reading|
|(Stock Price/Dow)x 1000||(Stock Price/DWA Sector)x 100||(Index/S&P)x 100|
There are 4 Combinations of Relative Strength.
|Best:Buy Signal and in X's||Improving:Sell Signal and in X's|
|Good:Buy Signal and in O's||Weakest:Sell Signal and in O's|
Investors will want to pay close attention to Relative Strength as the signals last, on average, two years while column changes last several months. In sector relative strength we pay most attention to the column. Even for traders, you want to be in the strongest relative strength stocks and sectors when going long and in the weakest relative strength stocks and sector when going short.