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Ask The Trader
Wednesday, May 16, 2001

Relative Strength

What's the best way to trade off relative strength? I subscribe to Investors Business Daily and they rank stocks according to their relative strength (among other parameters). Is this an important thing to focus on when trading?

Thanks, Manny

The relative strength charting tool is a simple yet effective way to confirm that you are buying a stock that has generated some institutional interest. The relative strength line is constructed by plotting a ratio of two market prices. In other words, you just divide one market entity by another.

When the ratio line is rising, the numerator is outperforming the denominator. When the ratio line is declining, the denominator is stronger. For this reason, we generally put the stock of interest in the numerator and either a broad market index or that stock's sector in the denominator. This way, we can get a good feel for whether we are buying a market leader or laggard. Most charting software will allow you to enter a stock, followed by a space and then a dash (/), then the sector or index symbol to come up with the ratio plot (or relative strength line).

IBD does a great job of ranking stocks by relative strength. They use a letter system where the strongest stocks by relative strength are awarded an A and the weakest get an E. They use the Wilshire 5000 (TMW.X) as the denominator since this is the broadest of the market indices.

The best way to trade with the relative strength indicator is to use it as a screening tool and then as a confirmation tool when combined with volume and or MACD. By first focusing on stocks that have a high relative strength reading (IBD B rating or better) you have just eliminated stocks that either have been experiencing selling pressures or that have been idling compared to the overall market or sector.

For shorter term trades you want to make sure that you are comparing your stock with its index (as pictured below) to make sure that it is currently under accumulation compared with its peers. For longer-term trades you want to compare your stock with either the S&P 500 (SPX.X) or the Wilshire 5000 (TMW.X) for a more general look into your stock's overall health.

Good Luck and Have a Profitable Trading Day

Craig Seidler
Assistant Editor

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