When and How to use Relative Strength Copyright © 2011 Linda Raschke and LBRGroup,Inc. All rights reserved.

Relative Strength History – Respected technicians, market practitioners and academics cite relative strength for the past 90 years. Theory – “The strongest groups get stronger”. Practice – Traditional RS investment models to short term day trading applications. Filters – market environment and volume,

Relative Strength Relative Strength is one of the most powerful tools for making money in markets. The theory is that the stronger a market is, the greater the supply demand imbalance, and the greater likelihood it will continue to outperform other markets. Relative Strength should never be considered a primary timing tool, but works best when used in a consistent framework using other market indicators. Like all indicators, it is a powerful tool in certain market environments but does not work well in other market conditions.

Relative Strength –History Robert Rhea (1933) wrote about relative strength in Barrons. He compared the percentage swings on an individual stock to the % moves on the Dow Jones. Gartley (1930’s) looked at stock groups using relative strength. He was among the first to quantify RS. His work laid the foundation for the concept of “beta”, defined by William Sharpe. Richard Wyckoff (1930’s) “buy relative strength on reactions”. Relative strength is measured by those issues that give up the least ground on the reactions down. George Chestnutt (1960’s) American Investor’s fund outperformed the Dow for 30 years. “choose the best performing stocks from the best performing industries.” He used punch cards and an IBM computer to follow a disciplined strategy. Edwin Coppock (1960’s) Did studies on relative strength and published in Barron’s. Relative strength is especially useful for intermediate and long term trading.

Relative Strength -History Robert Levy (1967) pioneered academic studies on RS. Over his test period in the 1960s, he concluded that 6 months was the optimal window by which to measure RS and this was used to predict the subsequent 6 month period. William O’Neil (1960’s) - “select from leaders with a look back of 6 & 12 months. Hold for next 6 and 12 months.” James O’Shaughnessy (1997) “What Works on Wall Street” Popularized Relative Strength among the upcoming quants.

When does Relative Strength work best and when should it not be used? RS works best in up-trending markets, in heavy volume markets, and thrusts off cyclical lows. It works well in both stocks, sectors, and commodities. It falls apart in strong downtrends, or right after a market has had an initial downside break. It also will under perform in a light volume trading range. Lastly, if the market has already had an extended markup, rotation will tend to take place.

When does Relative Strength work best and when should it not be used? RS works best in up-trending markets, in heavy volume markets, and thrusts off cyclical lows. It works well in both stocks, sectors, and commodities. It falls apart in strong downtrends, or right after a market has had an initial downside break. It also will under perform in a light volume trading range. Lastly, if the market has already had an extended markup or markdown, rotation will tend to take place.

Practical Applications Traditional investment models and look back periods. A 6- month look back is best, and a 4 week look back period performs worst. Measuring off cycle lows: Use of 2,3,or 5 period Rate of Change to determine the initial momentum thrust. Pattern recognition works well with swings, too. Trading in stocks and futures: Ranking the first 30 minute range, looking for the “Open-Drive” principle. Day trading in stocks or stock indexes: confirmation/non- confirmation and leadership Trading in commodities

Comparison of 4 indexes by visual inspection.

Detecting changes in leadership: pattern recognition vs. quantitative analysis. Wyckoff used pattern recognition.

Buy the RS leaders off Cycle lows. Relative Strength is determined by comparative structure of the swings.

KO divided by S&P 500 with 180-period moving average

PEP divided by S&P 500 with 180-period moving average

You can measure RS to see if it is rising or falling, increasing or decreasing in momentum. To obtain a relative strength line, divide the price of the stock by the price of a market index (or another stock if comparing the two). Price rising and RS rising is most bullish. Price falling and RS falling indicates the weakest scenario. Classic technical indicators can be applied to a relative strength line to highlight trend, confirmation and non- confirmation.

MCD divided by S&P 500 with 180-period moving average

DE divided by S&P 500 with 180-period moving average

Currently, oils shares are turning into the RS leaders again.

Which of these two stocks gave the best initial thrust off a cycle low in the indexes? (2-period ROC measures the initial momentum thrust)

Rank the position of a 3-period RSI at a cycle low or 3-5 days after the low. AA has one of the lower rankings no matter where you measure it.

Compare AA to WMT, which gives a higher RSI reading regardless if you measure it at a cycle low or shortly thereafter. Which performed best over the following week?

Day-trading stocks: Take (close – open)/(high – low) of the first thirty minute bar and sort for the highest and lowest readings. If you do not have a sorting routine such as radar scan offered by TradeStation, simple visual inspection works quite well. You are looking for that “open-drive” concept where prices move sharply off their opening level for the first 30 minutes. There will almost always be an intraday 15 minute bull flag, or use the reactions in the S&Ps to time entry as well. Do not use this strategy on light volume trading days. There will not be enough follow-through after the initial morning thrust.

First 30-minute bar can set tone for the day. Here are 4 stocks on the same day, which was a trend day down. First 30-minute bar can set tone for the day. Here are 4 stocks on the same day, which was a trend day down.

NYSE Volume – 30 minute bars: Look for higher volume inthe first 30 minutes when using relative strength to day trade.

Futures: First 30-minute bar off 7 AM reading- similar relative strength reading approach to day trading stocks. Futures: First 30-minute bar off 7 AM reading- similar relative strength reading approach to day trading stocks.

Same trading day with lines drawn at the 7 AM reading instead. Easy to see a grid of 20 markets this way!

Which markets will be weakest/strongest into the close?

The top 4 were the weakest one’s and close on their lows. Crude and EC hold up best (the red line marks the 7AM CST reading)

Which of the 6 markets will perform best on the next upswing?

EC and Gold had the largest swings down, and thus the next swing up was weaker.

Both the Swiss and the Yen were considered to be “safe havens” during periods of Arab turmoil and European debt crisis, but which market turned out to be the home run?