All traders, at one time or another, try to find the secret to success – the trading Holy Grail. There is no Holy Grail, of course, but I can share with you a secret that comes close:
If you want to make consistently large trading profits, trade strongly trending markets.
We all know of people with little or no trading or investment skills who were very successful during the Internet boom. It is no coincidence that there is a Wall Street saying “don’t confuse brains with a bull market”!
Very strong stock markets make even poor traders look good.
Trading can be likened to a boat race down a river. If you want to win the boat race, it makes good sense to find a very fast boat, and to drive it down the fastest flowing channel in the river.
So it is with the stock market. One can maximize one’s profits by trading the strongest stocks in the strongest sectors.
One of the saddest sights I see in trading is the people who buy stocks that are rising slowly. They think they are making money from their trading, and they are, however they are paying a large opportunity cost. They are not making as much money from their capital, safely, as they could be making.
Comparative Relative Strength (Spread Divide)
To find the strongest sector we look at the comparative relative strength of the market sectors versus the key market index (the S. & P. 500 Index). To use our boating analogy, we are trying to find the fastest flowing channel in the river.
Comparative Relative Strength is an indicator that allows a comparison of the price movement of a stock with another stock, sector, or index. The primary comparison being made is between similar stocks in the same industry or category. Comparisons can also be made between a stock and its competitors or a stock with the overall market index. Traders like to focus on trading in areas where the strongest up or down trends exist. It can be an individual stock or a specific group and sector.
Comparative relative strength is a term used to describe the relationship between any two markets. These can be stocks, indices, futures, options or warrants. Our aim is to see if a particular market is increasing, decreasing, or staying the same in terms of its strength relative to another market.
Comparative relative strength is not the same as the relative strength indicator (R. S. I.). The R. S. I. indicates the internal strength of an individual market.
To calculate the comparative relative strength of Market A in terms of Market B, we simply divide the price of Market A by the price of Market B. We then plot the result of this simple division as a line chart. (Market Analyst software calls Comparative Relative Strength ‘Spread Divide’.)
- If the line is rising, Stock A is increasing in strength relative to Stock B.
- If the line is falling, Stock A is weakening in strength relative to Stock B.
- If the line is flat, both markets are maintaining equal strength.
Note: At StockCharts.com, a ratio ticker symbol is used to create a Price Relative indicator. A ratio symbol consists of two ticker symbols joined together with a colon character (e.g., “IBM:$SPX”, “$INDU:$GOLD”). The value of a ratio ticker symbol is equal to the close of the first symbol divided by the close of the second symbol.
All of the usual line chart technical analysis techniques can be used to analyse the line chart. These include trendline analysis, pattern analysis and even the use of technical indicators.
The good news is that trends tend to be sustained and strong trends tend to remain strong. This allows us to use this technique to select stocks for the medium to longer term, and thus overcome the enemy of the stock trader – high overall transaction costs.
Remember that Stock A’s strength, when compared with that of Stock B, can be increasing (a rising comparative relative strength line), yet both stocks are falling in price. Stock A would, however, would be falling at a slower rate than Stock B.
To overcome this ‘problem’, one can simply calculate the percentage increase (or decrease) of the markets in question over a given time period. This process can be automated and literally hundreds of stocks can be scanned in a matter of minutes. (Market Analyst calls this scan ‘Relative Comparison’.) By using such a scan, we can isolate the strongest sectors and a few strong stocks from each of these sectors, in a matter of minutes.
Uses of Comparative Relative Strength
We have discussed how the concept of comparative relative strength can be used to isolate the strongest sectors of a given stock market, and in turn the strongest stocks from these sectors. This technique has other powerful and important uses. Some examples include determining:
- The relative strength of different world stock markets. This would help traders and investors to decide whether to trade or invest in overseas markets.
- The likely direction of the Australian dollar. If you trade the Australian dollar versus the U. S. dollar, plotting an indicator such as the relative strength of the Commodity Research Bureau (C. R. B.) Index versus the price of the U. S. dollar could be of value over time.
- Whether we are likely to experience inflation of deflation. Plotting the relative strength of bonds relative to the price of gold could help us to gain an insight into the inflation cycle… and so on.
Although comparative relative strength is an enormously powerful tool when used in the stock market, it should be a valuable tool of all traders. I use it as one of my key stock trading tools (it is outlined in detail as one key stock selection tool in my Stockmarket Master course). Any trader who tests it thoroughly will come to the same conclusion as market masters such as Martin Pring (U.S.A.), Stan. Weinstein (U.S.A.) and David Fuller (U.K.). All of these traders use, and advocate the use of, comparative relative strength.
Get with the strength!
Neil A Costa