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Now that the RS calculation and how RS charts are created have been defined, we need to learn
how to evaluate them. We are primarily interested in signal and column. The patterns of interest
are simple double top breaks and double bottom breaks. This identifies whether the RS charts is
positive (on a buy signal/ double top) or negative (on a sell signal/ double bottom). The column
is also important to identify the "near term" status of the RS chart. If the RS chart is in Xs
it shows that the stock is outperforming the index in the short term. If the chart is in Os then
the stock is underperforming the index in the short term. The RS signals are longer term. Typically
a RS signal will last for roughly 1.5 to 2 years.
This presents four potential scenarios, or conditions for a RS chart. They guide us as to the
suitability, potential productive holding period, and position management strategies. There are
4 potential scenarios discussed below moving from the strongest status to the weakest.
RS on a Buy Signal in Xs - This is the strongest reading for a RS chart. The buy signal shows
the stock outperforming the index longer term, and the fact that its currently in a column of Xs
shows that it is currently outperforming the index.
RS on a buy signal in Os - This status demonstrates that the stock is outperforming on a longer
term basis but is currently "taking a rest". As long as the RS chart remains on a buy signal the
RS is intact.
RS on a Sell signal in Xs - In this case the stock has been under performing the index. However,
the reversal to Xs indicates that on a short-term basis it is managing to show strength.
RS on a sell signal in Os - This is the weakest status of the four.
This indicates that the stock is significantly under performing the index and the recent action by the stock shows that it
continues to under perform the index.
Relative Strength is a measure of magnitude of the movement of a stock rather than a tool to determine
price direction. For instance, positive Relative Strength does not mean the security has to rise in
price. If the market falls 10% and the positive RS stock falls 5%, it has demonstrated positive RS.
Conversely the opposite would be true of a security on a RS sell and in O's.
Now we will cover an example of a RS and Trend chart and discuss how
we evaluate them in greater detail.
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