Stock markets are complex systems consisting of thousands of traders. At any given time, there are hundreds of people buying and selling stocks who have  diametrically opposite views. A number of metrics, charts and ratios have been developed to make sense of stock market movements and help participants make informed decisions. The broader context has to be understood for the efficient usage of technical tools. The relative strength comparison is a technique that is used in investing to ascertain if a particular stock or security is overvalued or undervalued in comparison to another security, sector or the benchmark.

Understanding relative strength

Relative strength comparison can be termed as a component of the broader value investing strategy. While value investing focuses on identifying stocks that are intrinsically undervalued and selling them at a higher price, comparative relative strength seeks stocks that may be fairly valued but can be sold at a higher price. Investors assume the prevailing trend to continue for relative strength comparison to be effective. If the prevailing trend suddenly reverses, investors may not get sufficient time to realise gains which could lead to losses.

Relative strength comparison is especially effective during long spells of market stability since it banks on the continuation of a prevailing strength. In the event of sudden disruptions like the Global Financial Crisis of 2008, comparative relative strength may lose effectiveness. Though relative strength comparison is used largely by stock market investors, it can also be used for other asset classes.

How to calculate?

As the name suggests, relative strength tells you about the strength of a security in comparison to another security or index. It is represented by a ratio. The relative strength comparison can be easily done by dividing the price of the base security by comparative security. For example, you want the relative strength of a stock XYZ. To get the comparative relative strength of XYZ, you will have to divide the current market price of XYZ with the BSE Sensex. If you use the Sensex as the denominator, you will get the comparative relative strength indicator of XYZ in comparison to the benchmark index. The usage can be modified and sectoral indices, as well as other securities, can also be used.

Types of relative strength comparison

The comparative relative strength of security can be of various types depending on the denominator being used. Generally, portfolio managers take into account the relative strength of stock with respect to the benchmark. However, the relative strength comparison can also be done with another security in the denominator. It is generally done with two stocks in the same sector. It provides the relative strength of a stock in comparison to its peers. It has to be noted that the relative strength comparison of two stocks is effective if there is a strong historical correlation between the performances of the two securities.  For instance, let us consider there are two telecom stocks XYZ and ABC. One can get the relative strength of XYZ by dividing the price of XYZ by ABC. The current market price of XYZ is Rs 100, while that of ABC is Rs 500. The relative strength of XYZ is 0.2.

The value gains meaning only when historical levels are taken into account. Suppose, the historical relative strength ranges between 0.5 and 1, then it is clear that XYZ is undervalued. The only way for the comparative relative strength indicator to increase to its historical level is an increase in the price of the numerator (XYZ) or a decrease in the price of the denominator (ABC) or a simultaneous increase in numerator and decrease in the denominator.

Conclusion

While calculating the comparative relative strength is not difficult, it is important to know the usage of the metric. The interpretation of the comparative relative strength indicator varies according to the type of indicator. In case of a relative strength comparison with a benchmark index, investors look for stocks that are displaying relative strength. In the case of pairs trading i.e. when the relative strength of a stock is calculated with its peers, like the XYZ and ABC example above, traders can take long and short positions depending on the prevailing value.  When the relative strength of XYZ is lower than the historical levels, investors can take long positions in XYZ and short positions in ABC. Relative strength comparison can be an effective technique when used in consonance with other tools and trends.