Relative strength: the recipe to compound fast.

Central dogma of a trade 2.1

We are resuming the series “The Central Dogma of a Trade”, where we are discussing what constitutes a trade.

In the first article, we saw that a trade constitutes 5 essential components, viz:

1. Determine the Market health.

2. Determine Leading sectors and leading stocks

3. Least risk entry

4. Trade management

5. Exit

We also discussed a comprehensive list of secondary market breadth indicators to help us determine market health. In this article, we will discuss how to determine the leading sectors and the leading stocks in the market currently.

2 words.

“RELATIVE STRENGTH”.

The only essential component to a trend following. I repeat, THE ONLY.

What is Relative Strength?

It basically means the strength/performance of a Stock (on an index or anything) relative to another.

It has 2 components:

1. Performance (against X), and

2. Time period

To understand this more clearly, let’s look at HDFC bank’s relative performance as compared to Nifty50 and Nifty Bank for the last 1 year vs the last 10 years (charts below)

1-year data: top image

10-year data: bottom image

Blue: HDFC bank

Yellow: Nifty50

Cyan: Nifty bank

As you can clearly see, on a 1-year timeframe HDFC bank has been an under performer with a 10% return as compared to Nifty50’s 13% and bank Nifty’s 23%.

Whereas, on a 10-year timeframe HDFC bank has been a mammoth out-peformer with 603% as compared to Bank nifty’s 397% and Nifty50’s 275%.

I hope by now, we are clear about what we mean by relative strength. We will now look at how to use it.

How to use relative strength practically in trading/investing?

Like everything else in trading, the answer to this question is also subjective. I will try to objectify that subjectivity here.

It simply depends on your timeframe. For swing traders, a time period of 1-3 months may suit them better whereas for a longterm investor/positional trader, a period of 6-12 months would work best.

Now, once you have identified and defined that time period for yourselves, the best time to enter a trade would be as early as the outperformance is being recorded on the chart. To be more specific, you can enter, as the Relative strength line on the Mansfiled relative strength indicator crosses 0, which would mean that the outperformance is just beginning. (link below, to my Youtube video where I show how to use the Mansfield relative strength indicator)

Should we not wait until the RS line shows clear outperformance?

My personal bias is No. But why?

As I am a swing/positional trader, the bulk of the move is already gone for me by the time the outperformance is evidently clear, in some cases the move might even be beginning to die (although some can continue for a long time as well). The flip side to this is, not all early outperformance might turn out to be a fullfledged sustainable move (hence progressive exposure, more on this in articles to come). So there is always a cost-benefit to any approach you want to take. Nonetheless, knowing the timeframe and what can be expected would help in managing the trade and trade expectations better.

PS: There are lots of Relative Strength indicators on tradingview which you can check out for yourself. They basically give you exact same data but in a different graphical representation. Some notable ones I used in the past are by Traderlion, and Bharattrader and my favorite one which i use now is by fyntrade. i have linked my youtube video on how to use this particular indicator above.

Next week, I will expand more on this and write about how to hunt for the relative strength pockets and the best stocks within those pockets. As they say, there is always a Bull market somewhere, you just need to learn how to spot them.

Cheers, have a great weekend.

See you soon.

Do reply here if you want me to have a look at any particular sector.