BALTIMORE (Stockpickr) -- Relative strength is one of the most important concepts in technical analysis, especially when markets are as anxiety-ridden as they are now -- but it's also one of the most misunderstood. In this Technical Primer, we'll take a look at what relative strength really is, as well as what it isn't.More importantly, we'll look at how this concept can help you beat the market, even in challenging conditions. For starters, relative strength isn't the same thing as RSI. RSI, the initialism for Relative Strength Index, is a momentum indicator based on a stock's recent gains and losses. It measures one point in time vs. another for a single stock. Relative strength, on the other hand, is simply the relationship between two securities. Not surprisingly, the fact that these two separate concepts have nearly the same name is a major cause for confusion for aspiring technicians. >>Are Stocks Headed for a Year-End Rally? At its core, relative strength (also sometimes referred to just as RS) is a tool for measuring a market's potency just as RSI is, but the key difference is in how they go about doing it. RS gets its name because it measures the strength of one security relative to another -- as a result of that, it's primarily a screening and selection tool. The simplest way to compute relative strength is by taking a stock's price and dividing it by the price of another security -- most often a broad market index. The resulting ratio doesn't mean anything in and of itself (after all, you're dividing one price by another unrelated price), but a plot of relative strength does. An increasing relative strength line tells us that a security is outperforming its denominator security, while a dropping line tells us that it's underperforming. The key word in the name is "relative" -- a rising relative strength line doesn't mean that a stock is increasing in value. It only tells us that it's outperforming the broad market. We'll get back to that in a bit. The Value of Relative Strength So does plotting the ratio of one security to another really have any value? According to academic studies, the answer is a resounding "yes." According to a number of academic research studies compiled by Professors Charles Kirkpatrick and Julie Dahlquist in their texbook, Technical Analysis: The Complete Resource for Financial Market Technicians, using positive relative strength to pick stocks has historically been a viable strategy that produces outperformance over the broad market.
Twitter and become a fan on Facebook.