Using Relative Strength To Find Opportunities

First, let's start by defining relative strength. It's a measure of one security's performance relative to another and is displayed as a fraction or ratio. The way that is expressed in the market is by being long X Rupees of the numerator and short an equivalent Rupee amount of the denominator.

If the ratio is rising, the numerator is outperforming the denominator. If it's falling, the numerator is underperforming the denominator.

Why is this so important in an environment where there aren't many clear trends on an absolute basis?

Market-neutral trades allow you to take advantage of the difference in performance between two securities, as opposed to making a pure directional bet on one of them.

Market-neutral "pairs trades" can be profitable in a number of ways.

1. Both stocks go up, but the numerator goes up more
2. Both stocks go down, but the numerator goes down less
3. The numerator goes up and the denominator stays flat or goes down
4. The numerator is flat and the denominator is down

By positioning ourselves this way, we create several opportunities to profit as opposed to simply betting on a single stock going up or down.

The second thing that's important to know is that the same type of analysis that we perform on an absolute price chart can be performed on a relative price chart.

Let's take a look at Ambuja Cements relative to the Nifty 500. Here, we see prices of this ratio are finding support at the same level that they began to rally from in 2009. Over the last two years, prices have been carving out another bottom at this major support level and are now turning higher.

Click on chart to enlarge view. 

So what does this tell us? It tells us that Ambuja Cements is a stock that will likely outperform the Nifty 500 going forward.

That information means different things for different market participants.

If you're a long-only manager (or someone looking for trading opportunities on the long side) that means you may want to consider adding it to your portfolio to help outperform your benchmark. If you're someone who is focused on shorting stocks it tells you to avoid this stock since it's now outperforming, not underperforming the broader market.

That brings us to the next question. If this ratio represents a market-neutral strategy, why are we looking at stocks relative to the Nifty 500...which is not an index we can actually trade?

The reason is that the exercise we performed was for informational purposes only. It's a starting point for our analysis, not the ultimate conclusion.

The Nifty 500 represents the 500 liquid stocks that we can be long and has representation from every industry group (everything from Banks to Paper and Textiles). The Nifty 50 is the broad market index we can actually trade (and short to put on a pairs trade), but using this would not provide an accurate representation of each stock's performance.

The Nifty 50 is a Large-Cap Index that doesn't have stocks from every industry group in it, so comparing a Mid or Small-Cap stock or a stock from an unrepresented industry to the Nifty 50 would put it at a clear disadvantage and misrepresent its relative trend.

During our Conference Call, the exercise of comparing every stock in the Nifty 500 to the index was to identify which industry groups had the most stocks outperforming the index. It gave us a "birds-eye view" of the playing field that we can now use to inform our decisions in the market.

By identifying those areas of strength (and weakness), we can now move forward with the next step in the process...comparing those strong stocks to the Nifty 50 to identify which "pairs trades" are at actionable levels. What market-neutral trading ideas can we take advantage of today?

Here's Ambuja Cements relative to the Nifty 50. Prices are finding support at the 2008-2009 lows once again and are now trending higher. From our perspective, as long as prices are above 0.0174, then we'd expect further upside towards the former lows of 0.0242.

Essentially, we're looking for Ambuja Cements to outperform the Nifty 50. To express this thesis, we're buying Ambuja Cements and shorting an equivalent Rupee amount of the Nifty 50 Index...capitalizing on the differing performance of the two securities as opposed to simply betting on the absolute direction of either of them.

The last thing to say on this subject is that the Y-Axis is important to pay attention to when charting and trading these relative strength (ratio) charts. Remember, we're looking at the price of one security being divided by another. So while the ratio may appear to be moving slowly on the chart, it may still represent a large percentage change.

For example, in the Ambuja Cements/Nifty 50 chart above, a move from 0.0198 to 0.0242 represents a 22.22% change. Don't let the small numbers on the y-axis fool you, there's a lot of juice in these types of trades if you have the patience to let them play out over months, quarters, and years.

So that explains our thought process and how we're using relative strength to find market-neutral opportunities in the current environment.

If you want to try charting these ratios yourselves, you can do so using free tools like TradingView.com. Simply type in the security's symbols as a fraction like so NSE:AMBUJACEM / NSE:NIFTY.

Premium Members can access our list of other market-neutral trade ideas that we're taking advantage of.

Thanks for reading and let us know if you have any questions.

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Allstarcharts Team