Relative Strength Can Unlock Serious Profits

By TradeSmith Editorial Staff

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Some stocks keep making new highs week after week no matter how the market behaves.

Take Zoom Video Communications (ZM), which gained 57% while the S&P 500 plunged 33% from Feb. 21 to March 23 in 2020.

Over the next 210 days, shares of ZM skyrocketed 256% before topping out.

This stock demonstrated relative strength compared to all the others in its sector and the broader market.

I want to show you how to use relative strength to uncover investment and trade ideas that carry enormous profit potential.

And if you hang on to the end, I’ll show you a few juicy selections from TradeSmith Finance.

What is Relative Strength?

Relative strength looks for a divergence between a stock and a basket of stocks or a benchmark. The benchmark can be an index like the S&P 500, or it can be more focused like a sector.

We can also compare one index to another. For example, the Nasdaq 100 far outperformed the Russell 2000 small-cap index over the last decade.

Stocks that outperform others tell us that buyers want that particular stock more than all the others. It signals to investors to take a deeper look for a potential position.

For me, it’s a great way to sift through the thousands of stocks out there and focus my research on those that already demonstrate promise.

A lot of folks struggle with this concept because they feel like it forces them to buy high and sell higher. This is true. Relative strength relies on the momentum of buyers to continue pushing a stock higher.

But there’s actually data that supports this.

For example, technology stocks didn’t just outperform small caps; they outperformed nearly every other sector in the last decade.

In fact, many momentum ETFs tend to outperform their benchmark indexes.

Take Invesco’s S&P 500 Momentum ETF, SPMO.

You can see below how the S&P 500 Momentum Index (and the ETF) outperformed the S&P 500 benchmark over the last several years, including during the 2020 collapse.

One of the biggest divergences came in during the dot-com bubble.

From 1996 to 1998, the Nasdaq 100 nearly doubled as new tech companies blossomed, despite many not making a single dime in revenue.

By the end of 1998, Wall Street analysts predicted a market collapse.

They were eventually right. But not before the Nasdaq 100 nearly doubled again over the next two years.

While we can certainly use this for broad investing strategies and ETFs, the idea of relative strength and momentum gets even more powerful as you look at individual equities.

Take SunPower (SPWR) for example.

TradeSmith Finance picked up on the stock’s momentum back on Aug. 27, 2020.

You see, shares of SPWR had shot up 51% between Aug. 20 and Aug. 27, far outpacing gains by any of the indexes and most stocks.

The Green Zone signal was triggered that day at $11.05.

Shares continued to soar to a high of $54.01 in late January before triggering a Red Zone exit in our system in May for a whopping 114% gain.

How to Identify Relative Strength

I want to find a stock that exhibits better returns over time, whether it be days, weeks, or even months.

There are two ways to measure performance.

In the first method, I look at the total gains for our one stock and a basket of stocks between a start and end date. This is what I did with Zoom.

This is a more traditional way to measure relative strength and is best suited to finding extreme outliers, such as in the Zoom example.

The second way is to take the average performance by day between two dates.

For example, if a stock’s performance relative to the S&P 500 over a five-day period measured 5%, 10%, -2%, -2%, and 3%, the average performance is 2.8%.

This method tells us more about the consistency of buying pressure underneath a stock.

Ideally, and in many cases, both methods will highlight similar stocks.

You can use TradeSmith’s tools to find these outlier stocks. But if you don’t have our tools, there are a few quick and easy ways to find stocks with relative strength.

  • Search for stocks with the largest percentage gains over the last five trading days (excluding pharmaceutical companies and buyouts).
  • When markets are trading down heavily on the day, find stocks trading higher than the previous day.
  • Look for stocks near their 52-week or all-time highs.
  • Use the Relative Strength Index (RSI) for a stock and filter for readings above 70.
    • The RSI is a technical indicator with a range of 20 to 80. For our purposes, we’re going to use it to filter for stocks with an RSI over 70, which indicates heavy buying recently.

Stocks Currently Showing Relative Strength

Now, I promised you some juicy picks from TradeSmith Finance that fit into our relative strength topic.

Here is a quick peek at the top results that identify stocks with strong upward momentum and relative strength.

What’s really cool about these tickers is they all carry a high “conviction factor” based on the number of our strategies that recommend these stocks.

And trust me, there’s plenty more where this came from.

For now, I want to hear whether you’ve used momentum in your selection criteria before. How did it go? If not, what questions do you have about using the RSI and other momentum indicators?