|
As the old saying goes, “Everything is relative.” This certainly rings true in trading. It is important to ensure that things are compared on relative terms. As I’ve pointed out in previous articles, saying that the market had the biggest points move in history is irrelevant as prices were lower in the past. What matters is the percentage movement or better yet, the average range.
Stock analysis can also fall into this kind of trap. For example, if one stock went up $10 and another went up $1 in a single day, which performed better? The correct answer is we don’t have enough information to establish this. If we say the stock that moved $1 opened at $0.50 and the stock that moved $10 opened at $100, suddenly the stock you would have preferred to own becomes very apparent.
This is why the Relative Strength Comparison (RSC) Indicator can come in handy. It takes things a step further and enables you to relate two markets back to a common measure. While there are a number of ways to calculate relative strength, the most common is simply to divide one symbol by the other. This can be applied to all sorts of trading situations and almost any combination of symbols. By far the two most common uses however are comparing a stock to an index (sector or overall market) and comparing two like stocks/symbols.
Chart 1 shows standard relative strength of Yahoo vs the S&P 500 (SPX).
Chart 1
click to enlarge
The RSC paints a picture of how YHOO has performed in comparison to SPX. A rising RSC line means YHOO is outperforming over that specific period and a falling line means it is underperforming, again over that period. Keep in mind that a rising RSC does not mean YHOO is going up; just that it is performing better than the index. The reverse is illustrated in Chart 1, where we can see that while YHOO edged higher from July 2009 to April/May 2010, it did so at a slower rate than SPX, causing the RSC line to decline overall.
The main flaw with this simple version of the RSC is that its values for different stocks cannot be compared in any meaningful way, even when the same base security is being used. Looking to Chart 2 we can see that GOOG has an RSC value of 0.495 compared to YHOO’s 0.0138. This is because GOOG is trading around 600 while YHOO is closer to 16.
Chart 2
click to enlarge
For those newer to the markets, a higher last traded price doesn’t mean a stock is worth more. In this case, GOOG is a larger company than YAHOO, but by a factor of around 13 instead of 36 (583.72/16.24 = 35.94). The reason GOOG trades at a far higher price is that it has over 3 times less shares on issue than YHOO. This means that each individual share costs more.
However, I digress. To give an extreme example of why the standard RSC cannot be compared, Berkshire Hathaway A shares (BRK.A) are currently trading at 120,000.01, giving it an RSC value of 101.84. Neither 0.0138, 0.495 or 101.84 on their own can be compared in a useful manner.
With that in mind, there is a better approach to calculating the RSC. Instead of comparing the last traded price of each symbol, this modified formula calculates the percentage movements each day and uses their cumulative totals as the point of comparison. The main benefit of this approach is that the RSC values are now comparable between different symbols. If the symbols being compared are 100% correlated, the RSC will return a value of 100. This can be observed in Chart 3, where the SPX is compared to itself.
Chart 3
click to enlarge
Stocks underperforming the base security (from start date to present) will have a value less than 100. Stocks outperforming the base security will have a value greater than 100. Like in the YHOO example of the standard RSC, the trend can also be compared to establish out/underperforming over a given time frame.
As we can see from Chart 4, while YHOO has outperformed the SPX overall (RSC value greater than 100), in recent times that outperformance has slipped – shown by the decreasing RSC line.
Chart 4
click to enlarge
The key benefit of having an RSC value that is comparable, say across the whole S&P 500 constituents list (compared to the SPX), is that it can be used in market scanners. An excellent example is in ProfitSource, – to find stocks outperforming or underperforming the market. This is what sets it apart.
So it would seem that while everything is relative, not all RSC calculations are created equal.
Happy trading
Jordan Craw
|