Relative strength is a momentum investing technique that compares the performance of a stock, exchange-traded fund (ETF), or mutual fund to that of the overall market. It is calculated by taking the price of the security and dividing it by the price of a relevant benchmark index. This ratio is then plotted on a graph, which allows investors to identify whether the security is outperforming or underperforming the market.
The Calculation of Relative Strength
To calculate relative strength, one must first select a benchmark index that closely mirrors the overall market. This could be an index such as the S&P 500 for U.S. stocks or the FTSE 100 for stocks traded on the London Stock Exchange. Next, one must determine the performance of both the security and the benchmark index over a specific period, typically using daily, weekly, or monthly price data.
Once the performance data is collected, the relative strength ratio is calculated by dividing the price of the security by the price of the benchmark index. This results in a ratio that indicates whether the security is outperforming (ratio greater than 1) or underperforming (ratio less than 1) the market.
Interpreting Relative Strength
Interpreting relative strength involves analyzing the direction and magnitude of the ratio. If the ratio is trending upwards, it suggests that the security is outperforming the market. Conversely, if the ratio is trending downwards, it indicates that the security is underperforming the market.
Additionally, the magnitude of the ratio provides insight into the degree of outperformance or underperformance. A ratio significantly above 1 indicates strong relative strength, while a ratio significantly below 1 suggests weak relative stren
