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 value investing system. The relative strength is represented by a ratio. It is derived by dividing the base security by the security, index or benchmark which is to be used for the comparison. If the benchmark index like BSE Sensex is to be used for comparison, you will have to divide the current price of the security with 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 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.
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 overvalued, 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.
Difference in calculations
A relative strength comparison can be done simply by dividing the price of the base security with 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 with the current level of the benchmark. If the price of ABC is Rs 1000 and 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 the calculation. While the relative strength can be calculated easily, the calculation of the relative strength index is slightly complicated. It has to be computed in a two-step calculation.
RSI step one = 100 – [100/ 1+ average gain/average loss]
Generally, the value of 14 periods is used for the calculation of the initial RSI. After data from 14 intervals is calculated, the second level of the RSI formula can be used.
RSI step two = 100 – [100/ 1 + (previous avg. gain*13+current gain)/(previous avg. loss *13+current loss)]
The formula will give the value of RSI, which is generally plotted below the price chart of the stock. The second formula smoothens the result and hence the value will near 0 or 100 only during strong trends.
The utility of both indicators is another factor in relative strength vs RSI. The RSI is a momentum indicator which tells if security is oversold or overbought. For example, when the RSI is in the oversold territory and forms a higher low which matches with 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 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.
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.