Just as with any investment strategy, there are many ways to calculate Relative Strength. Although many of those methods have shown the ability to generate outperformance over time, Relative Strength seems to have a sweet spot in the intermediate term range that leads to the best results over time. Too short of a lookback will include too much market noise that ends up clouding the actual Relative Strength picture. And too long of a lookback generally includes too much mean reversion to be able to develop a meaningful Relative Strength picture.
We think using Point & Figure Relative Strength is a very effective tool for cutting out that market noise to focus on the intermediate term rankings among a universe of securities. It also provides clear signals that we can use as the basis of a process for investing in Relative Strength.
Some of the most popular methods for calculating Relative Strength use a simple time-based look back window. Price at the end of the lookback period is compared to price at the beginning of the lookback period. In this case, Relative Strength rankings are based only on the percent change between these two points. This method can be highly sensitive to the starting date chosen for the strategy.
Point and figure allows us to incorporate the additional price data between those two points to get a more accurate picture of the overall momentum profile and not just two data points, which does not leave us as reliant on a strong security performing well at the exact right time for it to show up in our Relative Strength analysis.
Point & Figure Relative Strength Research
To develop a point and figure Relative Strength chart, we divide a security’s price by the price of a benchmark, multiply that number by 100, and plot the resulting value as we would any point and figure chart.
Just as with our standard point and figure charts, we alternate columns of Xs and Os, switching columns when the RS Value has reversed enough to register 3 plots in the new column. In the case of a Relative Strength chart, a column of Xs means the ratio of the security’s price over the benchmarks price is increasing, which means the security is outperforming the benchmark. A column of Os means the ratio of the security’s price over the benchmarks price is decreasing, which means the security is underperforming the benchmark.
Again, just as with our standard Point & Figure charts, Point & Figure Relative Strength charts create patterns as the chart hits new highs or lows. A chart in a column of Xs that reaches a point above the previous column of Xs is on a buy signal relative to the market. A chart in a column of Os that reaches a point below the previous column of Os is on a sell signal vs. the market.
The Point & Figure column and signal give insight into the intermediate and longer-term direction of momentum respectively. Securities on a buy signal and in a column of X’s would be considered to have the best Relative Strength. Securities on a sell signal and in a column of O’s are considered the weakest and would be securities you would want to avoid.
As shown in our whitepaper on Point & Figure Relative Strength Signals, the securities that are on a buy signal relative to the benchmark tend to perform best over time, and the securities on a sell signal relative to the benchmark tend to underperform significantly. This shows that Point & Figure can help you build a simple process for generating outperformance in your portfolio by systematically allocating to high Relative Strength securities.