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How to find stocks to trade - Relative strength analysis
  • : December 22, 2016
  • : Prashant Shah

Relative strength analysis explained
This post explains the method of Relative strength technique to derive the list of candidates  for short-term to medium term trading. It is an attempt to convey the logical method of deriving the list of candidates so that it can be followed consistently.

The concept of Relative strength is very popular but truly underutilised by market participants. It is very simple and effective method of measuring performance of an instrument. Don't confuse it with RSI indicator due to similarity in name, they are entirely different methods.

Ratio chart

If we divide the price of one instrument with that of another, we get ratio of their prices. For example, if Bank Nifty is trading at 18000 and Nifty at 8000, we get the ratio of 2.25 if we divide the price of former by latter. Bank nifty is a numerator in this case and Nifty is denominator.

It is the ratio of one price to another for that particular period. This way, if we derive the ratio of two instruments on daily basis, we can plot the daily ratio chart by connecting them. It will look similar to usual line chart plotted by connecting two prices.

Refer daily ratio chart of Bank nifty to Nifty shown below.

22 dec

The ratio line shown in the chart can be analysed and we can apply different techniques of analysis on the ratio charts as well. But think of it.. what does rising ratio mean?  For ratio line to go up, numerator instrument will have to produce stronger number than denominator instrument. Hence rising ratio line indicates that numerator is outperforming denominator and falling ratio line suggests that it is underperforming denominator. Note that outperformance doesn't necessarily mean that numerator is rising when denominator is falling. It is outperformance when former is rising more than latter or falling less than it.

So when ratio line in the chart shown above is rising, it shows that price of Bank nifty is outperforming that of Nifty. This can become significant information and we can utilise it in different ways. Below are the major ways to take benefit of ratio charts.

1 - Pair trading
2 - Strength analysis - Sectoral analysis
3-  Intermarket analysis

Pair trading is popular market-neutral trading strategy among traders where both the instruments are traded simultaneously. For example, when ratio line rises, numerator can be bought and denominator can be sold. People use mean reversion techniques on Ratio charts.

Sectoral analysis can be performed on Ratio charts by analysing ratio charts of different sectors against Nifty (broader market index).

22 dec

22 dec

Above chart shows channelling and trend line analysis on ratio charts. Ratio chart of Bank Nifty has remained in rising channel line for long time showing the better performance of Bank Nifty index. Nifty IT ratio line chart has broken bearish trend line and seems to have broken out from bottoming formation.

Intermarket analysis is part of Technical analysis which examines correlation between major asset classes such as stocks, bonds, commodities and currencies. John Murphy has explained it in detail in his classic book on Intermarket analysis. Knowing the relationships between these asset classes can help the investor to determine the stage of investing cycle.

P&F Relative strength

Point & Figure is a world of objectivity. We can plot P&F chart of ratio line which is known as P&F relative strength chart. Ratio chart of Bank Nifty to Nifty shown above can be plotted as P&F chart as shown below.

22 dec

P&F patterns and formations make it very easy to read and make the decision making simpler. Of course analysis can be performed on P&F RS charts but they are very useful from trading perspective. Mean reversion techniques can be performed on P&F RS charts as well, but trending techniques on these charts are my favourites particularly due to the objective riding technique. All other method of analysing ratio chart are also applicable to P&F RS charts.

How to take benefit of TradePoint to use it

P&F Relative strength chart scanner in TradePoint helps in finding the outperforming or underperforming sectors / stocks against denominator. The denominator can be a broader market index Nifty or sectoral index.
We have designed the clear method of performing this analysis which can be done in 3 steps.

Step 1 - Sector analysis

Open the P&F RS scanner from the scanner menu.  Put Nifty at scrip 2 which is a denominator instrument.  And select Nifty - all sectors as Numerator group. Double top buy is a basic bullish P&F pattern which can be scanned on these charts.

By clicking on scan it will generate the list of sectors that are outperforming Nifty.  Same way, double bottom sell signal scan will help in knowing the list of sectors that are underperforming the Nifty.
22 dec

22 dec

Step 2 - Sector leaders

We come to know about sector performance in step 1. Next step is to find the leaders among these sectors. In the above example, Nifty Energy is one of the sectors outperforming the broader index. Hence put Nifty Energy index as denominator and Energy-index group as numerator and scan bullish signal, it will generate the list of stocks outperforming the Energy index. Similarly, chose Nifty Metal as denominator and Metal index group as numerator for bearish signals to find out the underperformers in Metal index.

22 dec

So we get candidates that are leading or dragging the sector index.

Step 3 - Individual stock analysis
Open individual charts of derived instruments and look for trading opportunities based on pattern or other methods of analysis.

This is Top-down approach of trading where we analyse the sector performance first and then responsible ingredients. Note that, other P&F patterns or indicators can be utilised instead of basic patterns for these scanners, although basic patterns also generate good results. Basic formation scan will produce short term trades and indicators will show the list of stocks from medium term perspective.

Individual analysis of index can complement this method of analysis. For example, if Nifty setup is bearish, it is better to hunt for opportunities in underperforming sectors and vice versa.