Savvy stock investors consistently measure the performance of their securities. While there are seemingly countless ways to do this, a well-established method is to gauge relative strength, i.e. looking at the stock's movements against overall market performance or that of another benchmark, often an index like the S&P 500 or the Nasdaq Composite Index. The relative strength calculation is especially valuable in momentum investing, whereby stockholders exploit existing market trends.
Knowing the right relative strength formula to use is central to determining the optimal investment strategy. Fortunately, the relative strength calculation is as simple as it is telling for holders of assets.
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Major Stock Indexes
While the number of indexes rises into the thousands, the three principal indexes consulted by analysts are the S&P 500, the Nasdaq Composite and the Dow Jones Industrial Average. These sources provide trading momentum indicators that give evidence of the trading population's inclination toward or aversion to risk. Each index uses an established methodology to quantify the price performance of a grouping of stocks and other securities.
For instance, the S&P (Standard and Poor's) 500 are selected not only on the basis of capitalization but also trading history, liquidity and a host of other variables. The Dow Jones Industrial Average focuses on 30 of the biggest U.S. companies with the most financial clout. Price is historically its principal influencer. Meanwhile, the Nasdaq specializes in technology and, unlike the others, will include smaller ventures with lower market capitalization.
Read More: What Does the Dow Number Mean?
Relative Strength and What It Conveys
The old adage about buying low and selling high does not quite apply to relative strength investing. More accurately, these investors buy expensive stocks to sell them at even higher prices. The underlying assumption, more conservative investors would say presumption, here is that upward trends will continue uninterrupted.
Using a given index as a benchmark, these investors examine the performance of companies within their purview. Most scrutinized are those where the stock value is rising the quickest or falling the slowest.
Given its assumptions of continued momentum, relative strength investing works best during periods of economic and geopolitical stability as opposed to volatile stretches. The financial crisis of 2008, as a case in point, saw violent reversals in stock prices that adversely, and suddenly, affected investor attitudes. As a measure of future performance, relative strength can also be applied to real estate, commodities and derivatives.
Relative Strength Formula for Stocks
Use the history of a stock's price to begin with. Two weeks is sufficient, but a longer period is preferable. In separate columns, one for gains and one for losses, record the daily changes in value. Sum up each column, omitting a negative sign for losses – absolute value is the intent here.
Dividing the totals over the number of days of the chosen period gives the averages of gains and losses. Subsequently, divide the average gains over the average losses. Here is the relative strength of the stock in question.
Relative Strength Calculation for an Index
The same procedure works for an index, except that all of the price changes – increases and declines – are tallied and then averaged over the same duration. Likewise, dividing average gains over average losses reveals the relative strength of that index.
If the individual stock is performing in a superior fashion against the index as a whole, it shows promise as an investment. If, on the other hand, its behavior is sub-par in comparison, an investor has cause to think twice about it. Momentum investing is more art than science.
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- A stock's relative strength can be used to find its place in the relative strength index, or RSI. RSI is an indication of a stock's momentum in the market. To calculate RSI, add 1 to a stock's relative strength rating. Divide this figure from 100 (i.e.: 100/x). Subtract the total from 100 to find the stock's relative strength index rating. An RSI rating over 70 indicates that a stock is being overbought, while a rating under 30 means the stock is being oversold.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.