Relative Strength vs Relative Strength Index

Relative strength compares a stock's performance to a benchmark, whereas the Relative Strength Index leverages internal momentum to determine overbought or oversold conditions.  These two indicators assist traders in evaluating trend leadership and price strength from various perspectives and viewpoints.   

Relative strength identifies outperforming stocks, whereas RSI helps to time entry and exits based on momentum indicators. Using both combined gives a clearer picture of market direction, allowing investors to assess trend quality and find prospective trading opportunities. This article describes how RS and RSI function, their distinctions, and how they complement one another in technical analysis. 

Key Takeaways 

Relative strength 

The relative strength is a technique that compares the value of a security to another security, index, or benchmark. The relative strength can be considered to be part of the momentum investing system. The relative strength is represented by a ratio. It is derived by dividing the base security by the security, index, or benchmark that is to be used for the comparison.  

If the benchmark index like the BSE Sensex is to be used for comparison, you will have to divide the current price of the security by the level of the Sensex. Another stock of the same sector or a sectoral index can also be used to derive the relative strength. In the case of relative strength comparison between peers, it is important to compare stocks that have a strong historical correlation.  

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 ₹100, while that of ABC is ₹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 the numerator and a decrease in the denominator. 

Relative strength index 

The relative strength index, or RSI, is a technical tool used in momentum investing. The RSI is represented as an oscillator, which is a line graph with two extremes. The RSI has a value between 0 and 100, which is calculated by taking recent price movements into consideration.  

An RSI value of over 70 is a signal of the stock being in the overbought territory and is hence overbought, while a value lower than 30 is a signal of the stock being in the oversold territory and is therefore undervalued. To take action based on the RSI, investors should take another indicator into consideration to confirm the prevailing trend. 

Analysing the Role of Relative Strength in Investing 

The relative strength concept is important in determining which securities outperform their peers or benchmarks over a given time period. It assists investors in determining where market power is concentrated, allowing them to focus on assets with steady upward performance rather than those that trail behind. 

Relative strength, in simple terms, refers to a stock's comparative momentum versus another asset, rather than its absolute price change. For example, if two stocks rise in value, but one rises quicker, it has more relative strength. This enables portfolio managers to distribute capital efficiently and manage sector-specific diversity. 

To identify prospective investment opportunities, relative strength investors usually start with a benchmark like the Nifty 50 or the BSE Sensex. They then seek out companies that have outperformed competitors, either by increasing faster during uptrends or falling less during downturns. This contrast helps in identifying stocks that consistently outperform the market. 

This method may be applied to entire sectors or asset classes through index funds, exchange-traded funds (ETFs), or real estate investment trusts (REITs), in addition to individual equities. Advanced traders may even apply relative strength to commodities or derivative instruments, broadening the notion to multi-asset momentum investing. 

However, investors have to keep in mind that relative strength works best in trending markets. In volatile or sideways situations, relative strength signals may provide deceptive signs of leadership. As a result, it works best when paired with other indicators, such as moving averages or volume patterns, to validate the underlying trend. 

Practical Applications of Relative Strength: An Example

The relative strength indicator can be used in various market situations to identify high-performing assets. Suppose an investor analyses two automobile stocks, Stock A and Stock B. Stock A appreciates 25% in six months, whereas Stock B climbs just 10%. Plotting the price ratio (Stock A ÷ Stock B) over time confirms Stock A's sector leadership with a rising relative strength indicator. 

Traders may use this information to rebalance their portfolios, moving weight towards outperforming equities and minimising exposure to laggards. Institutional investors use this strategy to identify sector rotation, such as switching from defensive sectors like FMCG to cyclical ones like capital goods, as momentum moves. 

In the Indian context, relative strength analysis may be used for ETFs and sectoral indices, helping investors in detecting early signs of trend reversal. However, since market circumstances may change quickly, it should be used in combination with an extensive technical approach rather than as a single indicator. 

Difference in Calculations 

A relative strength comparison can be done simply by dividing the price of the base security by the value of the reference index or security. For instance, suppose you have to do a relative strength comparison of stock ABC with the benchmark index BSE Sensex. Just divide the current market price of ABC by the current level of the benchmark. If the price of ABC is ₹1000 and the Sensex is at 30,000, the relative strength of ABC will be 0.033. 

A major difference between relative strength and RSI is the method of calculation. While the relative strength can be calculated easily, the calculation of the relative strength index is slightly complicated. 

The Relative Strength Index (RSI) calculation is a two-step process. 

Step 1: Calculate the Relative Strength (RS) First, determine the average gain and average loss over a 14-period window. 

Step 2: Calculate the RSI 

To ensure the data is smooth, subsequent calculations use a smoothing technique: 

This smoothed data is then plugged back into the RSI formula Usage  

The utility of both indicators is another factor in relative strength vs RSI. The RSI is a momentum indicator which tells if a security is oversold or overbought. For example, when the RSI is in the oversold territory and forms a higher low which matches a corresponding low in the price of the stock, it is a signal of a bullish divergence. In such a situation, any break above the oversold line can be used to take a long position. 

In the case of relative strength, the historical value has to be taken to take action. If the relative strength ratio is lower than the historical value, investors can take a long position in the base security and a short position in comparative security. 

Understanding the Concept of Relative Strength 

Unlike value investing, where the goal is to buy low and sell high, relative strength investing aims to purchase high and sell even higher. As a result, relative strength investors believe that the market’s present trends will last long enough for them to earn a profit. Any abrupt reversal of that trend will have significant consequences. 

Relative strength investors start by looking at a benchmark, such as the Sensex 30, to uncover potential investment options. They’ll then examine to identify which companies in that market have outperformed their counterparts, either by rising faster or falling slower than their competitors. 

Because relative strength investing is based on the assumption that current trends will continue in the future, it works best during periods of stability and minimal change. Chaos, on the other hand, can be harmful for relative strength investors since it can lead to sudden reversals of investing patterns, such as the financial crisis of 2007–2008. Investor psychology can shift in these situations, with yesterday’s investment darlings now being avoided. 

Although momentum investing is most commonly linked with individual companies, it can also be used to invest in entire markets or industrial sectors through index funds and exchange traded funds (ETFs). Similarly, real estate investment trusts can be used to make relative strength bets in other asset classes, such as real estate. Commodity futures, options, and other derivative products are examples of more exotic instruments that can be used. 

Relative Strength vs RSI: Which Is Better?   

The debate between relative strength index (RSI) vs relative strength is determined by the investor's individual goals and trading horizon. RSI focuses on internal momentum, which is how a company performs against itself over time, whereas relative strength compares performance externally to peers or indices. 

For short-term traders, RSI is more useful for spotting overbought or oversold areas, probable entry and exit points, and trend reversals. It works best when paired with moving averages or support/resistance levels. 

For medium- to long-term investors, relative strength is more effective in identifying outperforming sectors or equities. It identifies leadership patterns, allowing investors to follow the "winners" while avoiding underperformers. 

In essence, RSI evaluates the speed and magnitude of price change, whereas relative strength evaluates comparative performance. Combining the two provides a more balanced approach, RSI for timing entry and relative strength for selecting equities. 

Conclusion

The difference between relative strength and RSI is essentially a difference of perspective. The relative strength tells about the value of a stock in comparison to another stock, index, or benchmark, while the RSI tells about the performance of a stock in comparison to the recent performance of the same stock.