Written and copyright © 2010-2013 by Thomas N. Bulkowski. All rights reserved.
This article discusses a different kind of relative strength, that of comparing the performance of a stock versus the Standard and Poor's 500 index. Knowing the right combination
(rising or falling) when trading chart patterns can boost profits while lowering risk of failure.
Relative Strength Summary
- Select stocks with upward breakouts and falling relative strength before the chart pattern begins but rising on exit from the chart pattern.
- A reversal in relative strength from rising to falling, or falling to rising, leads to the largest average decline after a downward chart pattern breakout.
- After an upward breakout from a chart pattern, rising relative strength means good gains. Falling relative strength is bad news.
- For downward breakouts, falling relative strength means larger losses.
- The direction of relative strength is random after a breakout compared to before the chart pattern.
Relative Strength Background and Methodology
There are several types of relative strength. First, there's Wilder's relative strength index (RSI), which is a popular indicator. Then, there
are studies I conducted on relative strength of industries, where I compare the price performance of several industries to one another, and
stocks, whereby a trader or investor selects the strongest performing stocks to buy.
This study compares the performance of a stock with the Standard & Poor's 500 index.
The above chart shows an example of how I conducted the study. A symmetrical triangle appears outlined in red, bounded on the top and bottom
by two converging trendlines.
The relative strength line compares the daily closing price with that of the S&P 500's closing price, and it appears on the chart as a jagged blue line cleverly labeled
"Relative Strength Line."
Since this line is irregular, I applied a 22-trading day (about a calendar month) simple moving average to smooth it. That line appears in red as
a smoothed version of the more jagged relative strength line.
For the study, I looked at the slope of this line at three locations: the day before the start of the chart pattern, the day before the breakout, and a month after the breakout.
In this chart, the relative strength line is falling going into the chart pattern and rises when price breaks out of the chart pattern. It keeps rising a month later. As the chart shows,
price rises from about 23 to 33 (43%) in about 4 months.
I used 1,094 stocks with data stretching back as far as July 1991 and found 15,763 chart patterns. Not all stocks covered the entire period.
Relative Strength Results: Upward Breakouts
For stocks with upward breakouts, the following table shows the results based on the slope of the relative strength line.
The table shows that when a 22-trading day relative strength moving average line is rising the day before the chart pattern starts and continues rising the day before the breakout,
price climbs an average of 32% after the breakout. The rise is measured from the close the day before the breakout to the ultimate high, which is the highest high before price drops
by at least 20% (a trend change). Failures are 19%, meaning 19% of those chart patterns failed to rise at least 10% after the breakout. The 10% benchmark is an arbitrary setting, but
it is high enough for a trader to cover costs and make a small profit, assuming a timely sale.
The results show that the combination of falling relative strength leading into the chart pattern followed by rising relative strength on exit from the chart pattern gives
the best average percentage rise after the breakout (34%). Failures, at 16%, are also the lowest in the table.
The worst performing combination is a rising relative strength line going into the chart pattern followed by it falling on the way out. That combination gives an average rise
of 29% with the highest failure rate: 22%.
Relative Strength Results: Downward Breakouts
The following table shows the results for downward breakouts from chart patterns. The percentage loss column measures from the close the day before the breakout to the ultimate
low, which is the lowest low before price stages a 20% gain (a trend change). Failures occur when price drops less than 10%.
If the stock is falling faster than the market (falling "before chart pattern" and falling "before breakout"), I would expect a larger decline, and yet the table shows an 18% drop
occurs with a slightly higher failure rate (29%) under those
conditions. In other words, the results don't make intuitive sense.
For the best performance after a downward breakout, look for a reversal in relative strength, either from
rising to falling (21% loss) or falling to rising (21% loss) as measured on the day before the chart pattern begins and the day before the breakout, respectively.
Relative Strength Results: Post Breakout Relative Strength
As a final test, I looked at the post breakout relative strength results. This compares the gain (upward breakouts) or loss (downward breakouts) when relative strength is rising
and falling. The results are what I expected, but the percentage difference between the numbers surprised me.
The table shows that if relative strength is rising in a stock compared against the S&P 500 index after an upward breakout, the stock soars an average of 41%. This compares
to a rise of just 22% if relative strength is dropping.
For downward breakouts, when relative strength is rising, meaning the stock is maintain its current price better than the general market, the stock drops just 13% compared to
an average loss of 25% if the stock is weaker than the market.
Finally, don't expect relative strength to continue in the same direction after the breakout as it was before. If relative strength is rising leading to a chart pattern,
there is a 49% chance that it will continue rising after the breakout. That's random.
-- Thomas Bulkowski
Written and copyright © 2010-2013 by Thomas N. Bulkowski. All rights reserved. For every action, there is an equal and opposite government program.