Chapter 5: Comparative Relative Strength Indicator

Imagine you're interested in buying a new smartphone, but you're not sure which one to choose. You've narrowed it down to two options: the iPhone and the Samsung Galaxy. You've done some research on both phones, but you're still not sure which one is the better choice.

One way to come to a decision is to compare the performance of the iPhone and the Samsung Galaxy based on their features, price, and other factors that are important to you.

For example, let's say the iPhone costs 1,00,000, while the Samsung Galaxy costs 80,000. If you would divide the price of the iPhone by the price of the Samsung Galaxy, it gives you a value of 1.25. This means that the iPhone is more expensive than the Samsung Galaxy by a ratio of 1.25 to 1.

Now, let's say that you value camera quality and battery life the most in a smartphone. After doing some research, you find that the Samsung Galaxy has a better camera and longer battery life than the iPhone. Based on this analysis, you may consider buying the Samsung Galaxy since it is outperforming the iPhone in the areas that are most important to you.

What you have just done is run a comparative relative strength (CRS) analysis to compare the performance of two options and see which one is outperforming the other.

In stock markets, the CRS can help you in narrowing down your investment options by providing you with a way to compare the performance of different assets. By using the CRS to compare the relative strength of two assets, you can identify which one is performing better and consider investing in that asset.

Comparative Relative Strength (CRS) is an indicator that compares the performance of one security to another with a ratio chart. This indicator is also known as the Price Relative indicator or Comparative Price Indicator or Relative Strength Comparative. It's a useful tool for traders and analysts who want to gain insight into market trends and identify potential trading opportunities.

Read More: What is comparative relative price indicator?

The presumption behind the concept of comparative relative strength is that strength of a stock over the other will continue, similar to how a trend will continue, and that by recognizing the strongest investments, an edge can be obtained by investing in them until their strength abates.

Relative strength helps traders identify stocks that are performing better or worse compared to others in the market that can potentially capture higher returns and generate alpha, which represents the excess return of an investment compared to a benchmark. Relative strength analysis aids in optimizing portfolio allocation by emphasizing investments with the strongest relative performance. Monitoring relative strength can also serve as a risk management tool as stocks with weak relative strength may signal potential downside risk or deteriorating fundamentals, prompting traders to adjust their positions or implement risk mitigation strategies to protect against losses.

Please note that Comparative relative strength is not to be confused with the more common Relative Strength Index (RSI). RSI is an indicator that measures the strength of price action in a particular market. RSI indicates if the stock or security is overbought or oversold relative to its past price action over a specific period of time. You can learn more about RSI in the Technical Analysis Basic module.

Calculation of Comparative Relative Strength

The Comparative relative strength indicator is calculated by dividing the price of one security or market index by the price of another security or market index. The resulting value indicates the relative performance of the two securities or markets.

Comparative Relative Strength = Base security / Comparative security

• If CRS is in an uptrend àBase security outperforming comparative security

• If CRS is in a downtrend à Base security underperforming comparative security

For example, you can use the Comparative Relative strength to show the performance of TATA Motors relative to the Nifty50, or you can also compare the stock’s performance relative to its industry’s index, that is comparing it with Nifty Auto Index (CNXAUTO), or compare it with a competitor, maybe Maruti in this case. You can also compare the performance of two market indices, like comparing the Nifty Auto Index and the Nifty Bank Index.

Using CRS for analysis

The Comparative Relative Strength can be applied in a few different ways. We treat CRS's chart like any other stock chart, and we'll analyse it similarly to how we would any other security. To assess the direction of the CRS, you can use moving averages, support/resistance breaks, simple trend analysis, or other indicators. But, one of the most effective and profitable analysis is to look for bullish and bearish divergences in relative strength to look for a potential stock price reversal.

1. Trend analysis: You can use basic trend analysis to determine the CRS’s direction. The CRS operates just like any other line chart, so all the support/resistance, trendlines, and breakouts that are appropriate for any price chart are also appropriate for the CRS. As a result, the CRS also exhibits uptrends and downtrends, which are discernible by higher highs and higher lows, lower lows and lower highs, respectively.

2. Moving averages: You can also use a preferred moving average indicator for analysing the CRS chart. A basic observation is that the CRS may be in a long-term decline if it is trading below its 120-day SMA. Alternatively, if the CRS is trading above its 120-day SMA, an uptrend might be underway.

The chart above shows the weekly chart of TATA Motors (above pane) and the Comparative Relative Price of Maruti (TATA Motors/ Maruti) (below pane). A 150-day SMA is applied to both the TATA Motors price chart and the CRS chart. Notice that the CRS is in an uptrend since 2021, signalling the outperformance of TATA Motors compared to Maruti. However, after a major resistance breakout in Sep 2021, the price chart and CRS peaked in Oct 2021 and started forming lower highs and lower lows (downtrend). This downtrend indicates the underperformance of TATA Motors with respect to Maruti.

3. Bullish and bearish divergences: A bullish divergence in the CRS signals relative strength during a price decline. Alternatively, a bearish divergence in the CRS indicates weakness during an uptrend in the price chart of the stock. This approach is the most effective in analysing CRS and looking for potential reversal signs in the price chart of the stock.

What is a divergence, though, is a question you might ask.

Bullish and bearish divergences are technical analysis concepts used to identify potential trend reversals. These divergences occur when the price of a security moves in the opposite direction of a technical indicator. In our case, the technical indicator is the Comparative Relative Strength.

A bullish divergence occurs when the price of a stock is in a downtrend, but the technical indicator (here CRS) is forming an uptrend. This suggests that although the price is still in a downtrend, the momentum behind the price movement is weakening, and a potential reversal may be on the horizon.

On the other hand, a bearish divergence occurs when the price of a stock is in an uptrend, but the technical indicator (here CRS) is in a downtrend. This suggests that although the price is still in an uptrend, the momentum behind the price movement is weakening, and a potential reversal may be on the horizon.

A bearish divergence in the Comparative Relative Price signals relative weakness during an uptrend in the price chart of the stock. For example, the chart above shows DMART with the Price Relative to ITC. As you can see the price chart of Dmart has been in an uptrend from May 2021 to Sep 2021, however, the price relative chart has been in an uptrend during the same period. This demonstrates that there was a bearish divergence because the price relative chart did not support the upward trend in the price chart. The two charts' bearish divergence is a warning indicator that the price of Dmart may be about to reverse.  Notice that Dmart reached its high point on September 20, 2022, and it has since been in a decline, which is consistent with the trend in the price relative chart.

Summary

• The CRS can help you narrow your investment options by comparing the relative strength of different assets and identifying which is performing better.

• The Comparative relative strength indicator is calculated by dividing the price of one security or market index by the price of another security or market index.

• A basic trend analysis can help you determine the direction of CRS. One can also use a preferred moving average indicator to analyse the CRS chart.

• A bullish divergence in the CRS signals relative strength during a price decline. On the other hand, a bearish divergence in the CRS indicates weakness during an uptrend in the stock price chart.

• CRS should not be used in isolation but in conjunction with other indicators and analyses to make informed investment decisions.

In the upcoming two chapters, we'll delve into mastering the six types of market days, enabling you to anticipate reversals and breakouts while providing guidance for navigating the dynamic stock market landscape.