Investing in the stock market can be both exciting and intimidating, especially for beginners. There are countless metrics and indicators to consider when evaluating potential investments. One such indicator that can provide valuable insights for novice investors is a stock’s relative strength.
Popularized by renowned market wizards such as William O’Neil and Mark Minervini, a stock’s relative strength can let you know which stocks are of higher quality through price action.
Let’s dive into relative strength and how it can help traders perform better!
Understanding Relative Strength
Not to be confused with the RSI, a stock’s relative strength compares its performance to a broader market index. This comparison helps investors gauge how well a particular stock is doing in relation to the overall market.
In portfolio management, this can be likened to a stock’s alpha. The higher the alpha or relative strength, the stronger a stock has been compared to the market as a whole.
Why a Stock’s Relative Strength Matters
“I made 99% of my profits in the stock market by trading in leading names.”
– Mark Minervini
One of the primary reasons investors look at a stock’s relative strength is to identify if it outperforms versus others. When a stock consistently shows strong relative strength, it suggests that the company is doing better than others in the same industry or sector. This can be a promising sign for traders and investors.
Furthermore, a stock’s relative strength really shines during market retracements. A stock with strong price action during a broad retracement indicates the potential to be a market leader. This is due to the fact that when the market experiences downturns, fund managers will usually cut off lower quality stocks first. In effect, higher quality stocks will experience a weaker selldown which causes them to have a high relative strength reading.
Using Relative Strength in Your Investment Strategy
Now that you understand what relative strength is and how to calculate it, here are some practical ways to incorporate it into your investment strategy as a beginner:
- Screening for Strong Performers: As you regularly screen through the market, you can make it a habit to look for stocks that have a high relative strength or appear to be stronger than others. When the market is rallying, the stock shouldn’t be lagging behind others. On the other hand, as other stocks break below support levels during market turns, the stock should be staying strong above key levels. These stocks may be worth considering as top options for your investment portfolio.
- Confirmation of Buy or Sell Signals: When you’re considering buying or selling a stock, check if it’s significantly lagging behind other stocks. It’s normal to break out or rally a bit later than the broad market. However, if the delay is significantly long, it may be a sign that the stock’s relative strength is low.
Conclusion
Relative strength is a valuable tool for anyone, from beginners to experts, in the world of investing. It provides a simple yet effective way to assess a stock’s performance compared to benchmarks. By understanding and using relative strength, you can make more informed investment decisions as you add an extra layer to your stock picking criteria.
Remember that while stock’s relative strength is useful to know, it isn’t the holy grail of trading. It should always be used as a tool within your strategy.
