Education & Information
Relative Strength Charts for Individual Stocks
Once your overall market and sector analysis is complete, the next step in the investment management process is to select individual securities to purchase. In addition to the point & figure charts, relative strength charts will be invaluable in aiding one to select individual securities.
Relative strength charts for individual securities can help you isolate the strongest stocks within industry sectors.
They can also help further fine tune your sell discipline.
Simply said, relative strength charts for individual stocks record the price movement of the individual stock relative to a market index such as the Dow Industrials or S&P 500 Index. We want to narrow our participation in stocks that are performing better than the overall market averages. That means, it is likely to advance more than the market averages when the market is rising and it is likely to decline less than the broad market while the market is falling.
Relative Strength Calculation
- On a weekly basis divide the weekly closing price of stock by the closing price of the Dow Jones Industrial Average. Since these charts are long term and do not move around very often, weekly calculations are sufficient. However, if you have the time you can also perform this calculation daily.
- EXAMPLE
Microsoft closing price $45.03 – DJIA closing price 7836
45.03 divided by 7836 = .005746554
Move decimal over 3 digits
Number to chart is 5.75
- When this number is advancing Microsoft is performing better than the general market. When it is declining it is under performing the general market.
- Construct a point & figure chart with the relative strength number. See the chart below.
RS (relative strength) charts take the relative strength calculation from above and record the result in a point & figure chart. As with all point & figure charts, Xs are used to record a rising RS number while Os are used to record a declining RS number. Similar to point & figure charts, we are interested in the buy and sell signals generated on the RS charts. These charts are slow to develop. The RS chart for Microsoft (see below) covers an eight year span. They tend to speak to the longer-term trends of each stock relative to the overall market. Buy and sell signals are slower to develop than on regular point & figure charts, which record the stock’s price movement. Double top and bottom patterns are significant new signals as triple tops and bottoms and other patterns are rare on RS charts.
You can see on the chart below that the first sell signal in Microsoft’s RS chart was a double bottom at 7.00 in April 2000. That was when the second column of Os on the chart dropped below the first column of Os. This sell signal was a significant development for Microsoft’s shares as it was the first RS sell signal ever for Microsoft. For long time shareholders of Microsoft, this sell signal could have helped with the decision most every investor struggles with, “When should I sell?”
This was a great stock for many people for a long time. After a stock provides long-term profits, it is often emotionally difficult to part with it. Without an indicator such as the relative strength chart, it is purely guess work as to when a major turning point is at hand. The RS chart provides you guidance and takes the emotional influence and guess work out of the decision. It helps you make a more objective decision. Looking back, this was an ideal time to sell Microsoft as well as many other technology stocks that were giving similar signals simultaneously.
The major, long-term signals on RS charts are the new buy and sell signals generated on the chart. On an intermediate-term basis, a change of columns is also an important development, although carries less weight than the new buy and sell signals. Looking at the chart above, you can see Microsoft’s RS chart changed columns only five times in its history. The first was when it reversed down from a column of Xs to a column of Os in May 1999. This suggested that Microsoft shares would under perform the overall market over an intermediate time frame. The change of columns is not a sell signal by itself. It does, however, provide some guidance as to the relative strength of the share over the next several weeks or months.
The chart reversed back up in to a column of Xs in December 1999 as it made its high meaning that the shares of Microsoft traded at their highest level relative to the overall market at that time. This reversal up in to Xs now sets up the potential for a sell signal on the chart should it fall below the column of Os reached earlier in May. In April of 2000 the chart reversed down in to the second column of Os and it did proceed to drop below the first column of Os creating the important sell signal.
On a RS chart, the weakest combination is when the chart is on a sell signal and in a column of Os. This suggests weak relative performance over a longer and intermediate-term time frame. An investor would want to avoid owning stocks with this pattern on their RS chart.
After dropping to 4.25 later in 2000 the Microsoft’s RS chart reversed up in to a column of Xs in January 2001. This change of columns indicates the intermediate-term strength of Microsoft is improving. It is not a new buy signal, merely a reversal of columns. The RS chart’s main signal remains a sell and will continue on a sell until a column of Xs exceeds a previous column.
When a relative strength chart is on a sell signal and in a column of Xs it indicates the long-term relative performance is still poor, but it is experiencing better RS over the intermediate-term. Consider it a rally in an overall down trend. Conversely, when the main signal is a buy and the RS chart is in a column of Os it indicates the long-term relative performance is good, but the intermediate-term RS is strengthening. Consider it a correction in a longer-term advance.
On Microsoft’s RS chart, the third column of Xs continued to advance for about a year peaking in this column at 7.00 in January 2002. In April 2002 the RS reversed down into a column of Os again creating the weakest pattern, still on a sell signal and in a column of Os.
The strongest pattern on a RS chart is when the chart is on a buy signal and in a column of Xs indicating good RS over the long and intermediate term. On Microsoft’s chart, this could potentially occur if the next column of Xs, whenever it develops, exceeds the last column of Xs. It would take a reading of 7.50 for that to happen. However, it would change the main RS signal from a sell to a buy. Investors want to focus their new positions in stocks that show this pattern on their RS chart.
Relative strength charts are particularly effective when used in combination with traditional point & figure charts. In reviewing Microsoft’s P&F chart, you can see the long standing bullish support line was broken at the same time its RS chart gave a sell signal, April 2000. At that time, the price of Microsoft’s shares was trading in the upper $80’s. As of this writing, (September 2002), the shares are trading near $45. So you can see that the combination of the sell signal on the RS chart and the change of major trend on the point & figure chart was a very timely indication its shares would begin a prolonged decline.