Scanning for Profits, Part I: Using Relative Strength
Your quest for
trading profits begins with finding the right stocks to trade. Stocks with a
high EPS are a
good place to start because earnings, in part, power stock prices. The proof,
though, is in the pudding. What stocks are moving right now? To answer that
question, you need to look closely at Relative Strength.
Simply
stated, Relative Strength (RS) is a measure of a stock’s price performance
compared to either a market index, such as the S&P 500, or against a
universe of stocks. RS quickly tells
you whether a stock is outperforming or under performing the overall market.
Displayed
as a number from 1-99, a high RS indicates a strong stock; a low RS, a weak
stock. A Relative Strength rating of 99 means that a stock outperformed 99% of its
peers. By contrast, a Relative Strength of 1 means that the stock performed
worse than 99% of the others. A stock with a high RS is usually uptrending
(not always, since a stock going sideways will have a high RS if the overall
market is going down). Stocks with low RS are downtrending, performing worse
than most other stocks. A stock that is down 10% during a period when the
market is up 10% is showing poor relative strength.
The
Tradingmarkets.com Stock Scanner contains a database of about 5000 stocks. When
you perform a scan using this system, you’re measuring a stock against this
database. Ideally,
you want to focus on indices, sectors and stocks that are performing the best,
i.e. the ones that have high relative strength.
To give you an idea of what
RS looks like, several chart examples will help. Figure 1 (below) is a chart
of the S&P 500 Index as of 3/7/01.The index is obviously in a downtrend,
trading below the 50- and 200-day moving averages. This is the index used by
many as a measure of the overall market.
Figure 1
Compare this with Figure 2, a
chart of the Oil Services Index (OSX), also as of 3/7/01. This index, despite
a downtrend beginning early December, is trading in two-month-high territory.
Obviously, the OSX is stronger relative to the S&P 500. To say
merely, “The market was down” completely misses the boat, There are
always sectors and stocks moving, no matter what the overall market is doing.
Figure 2
Figure 3 (below) is a chart
of Rowan Companies, Inc. (RDC) for the same period. Rowan is a member of
the Oil Service Sector Index. The six-month RS is 83, which means RDC was
stronger than 83% of all other stocks in the Tradingmarkets.com Stock Scanner
database for that period. Despite a weak first three months, the price at the end
of the six-month period was very close to the price at the beginning of the
period, which is why the RS was so high — the rest of the market was
getting slammed. RDC held up well in a down market, and therefore, had
good relative strength. In the most recent three-month period, the stock
moved up nicely, and the 93 RS reflects this strong move. The stock had better
performance for the three-month period than it had for the six-month period.
Figure 3
During the three-month period,
RDC showed higher highs and higher lows and good thrusting days followed by
tradeable pullbacks — what a strong stock should have.
Now let’s take a look at a
weak stock during the same period.
Figure 4 is a chart of Cisco,
with a three- and six-month RS of 3. If you like to play the long side, there’s not
much here for you. Aside from a few rallies, the obvious trend here is down.
Any rally that materialized got crushed quickly. If you found a setup that
looked good, it was probably doomed from the beginning.
Figure
4
The fact is, bullish patterns
found in stocks with low RS tend not to work out as well (if at all) as those
found in higher RS stocks. No matter what the pattern looks like, or where the
support lies, or what your indicators say, or what (God forbid) the stars say,
it’s probably not going to work well in a stock with poor RS.
The moral? Focus on stocks
with strong RS.
The best is 99, but use at least
85 in your scans. This way you’ll only be looking at stocks that have a good
shot at reacting well to pattern setups. The
three-month relative strength is the more significant and timely number, since it
deals with the most recent price performance.
“I
like to short,” you say. Fine, then focus on stocks with low RS. Be
careful of stocks whose RS is too low — some of these have already
completed most of their downward move. For shorting, RS of 20-50 is a good
place to start.
One more thing: As
market conditions improve, high-RS stocks are more likely to bust out of the
gates quicker. Watch them.
To
learn how to use TM’s Stock Scanner to find the top RS stocks, click here.
Here For A Free 1-Week Trial To Dave Landry’s Daily Swing Trading Alerts
How To Trade Dave Landry’s Best Strategies