Relative Strength is the comparison between the prices of two financial instruments: stocks or indexes.
It’s possible to create an indicator that compares the historical series of Apple with the historical series of the Nasdaq index. Nasdaq Index is used as a benchmark.
Sectoral indices or sector ETFs can also be compared with the reference stock index.
Relative Strength using the Percentage Changes
A first rather simple system is to compare the percentage changes of the last x days of two actions.
In this way, a ranking will be created where in the first place we will find the title that has best performed.
Or, you can calculate the ratio between the percentage changes of X days. In this way, you haven’t a ranking, but an absolute comparison between two instruments.
Another method, always using the percentages of daily gain and loss, is to check how many times in X days the stock has outperformed the Benchmark Index.
Relative Strength using the Spread
You can also create an indicator that calculates the ratio of the entire time series of the two instruments. This is the spread chart you can get in Forex with currency pairs.
Let’s take EurUsd as an example; its graph is the relationship between the Historical data of the Euro and the Dollar.
Imagine you create a Netflix / Nasdaq chart when the line goes up; it will mean that Netflix is Outperform the Nasdaq and vice versa.
In this graph, it will be possible to insert a series of indicators, such as RSI, Moving Averages, etc.
Also, in this graph, it’s possible to find many patterns.
For example, assume that Netflix tends to outperform the Nasdaq Index for X days and then returns. In this case, we could use mean-reverting strategies to open a trade.
We could use an RSI indicator to predict that when the ratio of Netflix to Nasdaq rises above a specific value, then it tends to fall. So when the RSI of our Relative Strength Indicator exceeds a certain value, we can sell Netflix and buy Nasdaq.
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Resources: Wikipedia
