I’ve been reading some of John Person’s books lately. If you haven’t read anything by him, you owe it to yourself to get a hold of his trading books and read them. Seriously, they are some of the best material that I’ve read on trading.
I recently picked up Mastering the Stock Market again in preparation for my interview with John, and one chapter in particular caught my eye–the chapter on Comparative Relative Strength. (Note that this shouldn’t be confused with the “RSI” indicator, which is the “relative strength indicator”. The two are completely different.)
The basics of Comparative Relative Strength (CRS) is that you take one chart and divide it by another. The result is a simple line graph of the relative strength of the two markets. The line graph is the “difference” between the two charts.
For example, you might take the chart for JP Morgan (JPM) and do a relative strength comparison to the XLF financial sector ETF. What this does is it tells you how those two markets compare to each other. This is specifically interesting when you compare a stock and a sector ETF, because it tells you how well the stock is doing compared to the rest of the stocks in its sector. This is one way to do sector analysis.
Another way to use this would be to compare an individual stock with the S&P 500, which will tell you how the stock is doing compared with the broader market.
So, if the stock and the market we are comparing it to were exactly aligned, the result would be a straight line. Not interesting. However, when we compare JPM and the XLF, we see places where the stock is outperforming the rest of the financial market where the CRS line is trending up. That’s good to know, especially when evaluating a stock. You not only want to know how it’s doing individually, but especially how it’s doing compared to its sector.
I set up this exact pair on both the ThinkOrSwim platform and the Amibroker platform, and it works beautifully on both platforms. With ThinkOrSwim, the indicator is called RelativeStrength, and you set up the one stock in a chart, and set up the Relative Strength chart in a lower sub-graph. In Amibroker, it’s a function called RelStrength. It appears to be common enough that it is likely to be in other major platforms as well.
Here’s the best part of the chapter: you can apply a moving average to the Relative Strength line and use that as a buy or sell signal. The same way you might have used a moving average on just a stock in the past, you can now use a moving average on the relative strength of a stock within its sector. Because moving averages act like automated trend lines, you can program a system with a moving average to alert you of changes in the trend. That means when a stock begins to outperform its sector, you can be alerted of this fact (and buy); when the stock performs poorly compared to its sector, you can be alerted that the trend is over. John describes how you can use this CRS with a moving average system to write a tool to automate the signals. Though not a full trading system, it would be used to alert you of stocks that are outperforming the rest of the market, as well as stocks that are under-performing. The automated alert system would scan for the change in relationship to let you know when a stock was trending higher than the market or ending that trend.
If I were to pick one project to work on next, this would be it. Sector analysis is powerful, and it should definitely be part of your tool box.