The Three Ways I Use Relative Strength

Relative Strength (RS) is one of the most powerful indicators that I use to evaluate a stock. It is a proprietary ranking number found in Investor’s Business Daily or in the Daily Graphs Software product. My definition is simple: “relative” to the market, stocks showing better “strength.” Here is the official Investor’s Business Daily definition:

The proprietary RS Rating measures the price performance of a given stock against the rest of the market for the past 52 weeks. Every stock in the market is assigned a rating from 1 to 99, with 99 being the best. An RS Rating of 99 means that the stock has outperformed 99% of all other companies in terms of price performance.

My personal cutoff when selecting a stock is a RS rating of 90. I almost never buy stocks with a rating below 90. My reasoning is this: Harvard University rarely accepts students who score in the 23rd percentile of the nation’s SAT scores. They take only the best. So when selecting stocks, why should you settle with laggards or weaker-performing stocks? In addition, the key is not to simply buy stocks with the highest ratings. According to William O’Neil, the key is to “buy stocks that are performing better than the general market just as they are beginning to emerge from sound base-building periods.”

I use RS in three ways: short-term, medium-term and long-term.

Short-term: Intra-day RS can be useful when looking for day-trade ideas. For example, if the NASDAQ is down 20 in the morning, and you think it might rally back up, pay attention to stocks that are “holding up” better than the market. I like to look for stocks that are green or barely down on my screen with the theory that if they survived a morning selloff, they will most likely go higher if the market recovers.

The opposite is also true. If you purchase a stock in the morning and it doesn’t move when the market rallies, chances are it will become even weaker if the market fizzles. This is also a good way to look for short ideas intra-day. Again, these concepts can be used for shorter-term or day trading.

Medium-term: The best way to explain how near-term RS can be helpful is to use a real-time example. From 9/23/09 thru 10/2/09, the NASDAQ corrected approximately -5%. If you were looking to enter the market or add to positions near the NASDAQ’s 50-day moving average, the best trading ideas were the stocks that “held up” well during this pullback. For example, if you look at charts of $AAPL $BIDU $FIRE $CDE $EJ you will see how these stocks barely corrected when the market did. As soon as the selling pressure was lifted off the market, these stocks resumed their uptrend towards new highs.

Long-term: When the market emerges from a Bear Market, look for stocks that held up well during the big correction. For example, in the summer of 1998, the NASDAQ corrected approximately -32% during the LTCM collapse and the Russian financial crisis. When the market bottomed in October 1998, stocks such as YHOO CSCO MSFT AOL AMZN and EBAY were trading near their highs. In other words, the correction was like a “spring” holding down or compressing these stocks. As soon as the tension was released…BOOM! These stocks not only exploded to new highs, but also continued to be huge winners through 1999.

A more recent example is the March 2009 bottom. Stocks such as $GMCR $PEGA $EJ $PCLN and $NTES were all making new highs as the market was emerging from its Bear Market correction. These names went on to have significant gains in the ensuing six months.

So whether you’re a short-term trader or a long-term investor, you can see how relative strength can be used to help increase your success in the stock market.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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