by Ken Long

Relative strength is one of the most confounding topics to theoretical economists who believe in the rational man theory. The rational man theory is the conceptual underpinning for modern portfolio theory, which rests on the premise that everyone has access to information at the same time, in the same quantity, at the same cost, with the same goals and objectives, and will decide in the same way and always to maximize their net present value in every economic decision.

The main problem with the rational man theory specifically and modern portfolio theory general is that people and especially rational economists don't behave like rational economic calculating machines. Instead, they seem to behave like people, which is to say influenced by both intellectual and emotional arguments, with different levels of risk tolerance, threshold for action, goals and objectives and responses to stressing events.

One of the most persistent anomalies in terms of rational man theory is the persistent effect of momentum on stock market returns. The evidence of a momentum effect can be found in the academic and practical literature covering multiple time frames and different market types. Explaining this momentum effect a way has proven to be impossible and so rational man theory has had to accommodate in various ways.

For purposes of this essay however I want to look at the two basic ways in which relative strength is treated in the literature and in practice.

In the first case, relative strength can be thought of as evaluating an instrument against its own behavior over time. In this treatment, how instrument is trading lately is placed inside a broader historical context in order to determine if the instrument is stronger or weaker now than it has been traditionally. Typically, this idea has been used to find optimum times to enter and exit positions in the work centers on finding appropriate look back periods and thresholds for action.

In the second case relative strength can be considered as a way to evaluate an instrument against a population of other instruments in order to find an advantage in owning one asset over another. Typically, this is done against members of a larger population of the market such as an index or a region or a business sector. In this strategy, the trader is also looking for moments of outperformance that may be continued based on the momentum phenomenon.

The simplest way to assess relative strength is to divide price by price to develop a relationship on the current price and compare that relationship through time. It can be normalized on a scale of 0 to 100 were treated as a raw unbounded number. Normalizing on a scale of 0 to 100 allows for consistency and simplifies the comparison between different instruments against an index or against each other.

There are various formal treatments of relative strength that vary in some ways from this, but the general idea pertains to all relative strength indicators. It is one of the most powerful tools in the traders toolkit.