An important part of any technician’s analysis should be how the security he/she is analyzing is performing relative to the broader market, its sector, or another security. The way to do this is by creating a ratio chart of one security divided by another. The same analysis done to price charts can be applied to ratio charts.
To provide some perspective, absolute performance is the value determined by looking solely at how an individual security behaves in terms of its price change over a given period of time.
The Math Behind The Ratio:
To plot a ratio chart, you take one security and divide it by another. As an example we’ll use SPY/IWM. This ratio would give you a chart showing how the S&P 500 is performing relative to the Russell 2000.
What causes the ratio to rise?
- If SPY rises while IWM stays flat or moves lower.
- If both go down but SPY goes down less than IWM.
- If both rise but SPY rises more than IWM.
What causes the ratio to fall?
- If IWM rises while SPY stays flat or moves lower.
- If both go down but IWM goes down less than SPY.
- If both rise but IWM rises more than SPY.
Relative strength is when the underlying security being studied is outperforming the security it is being compared to. The below chart is a ratio chart of FB/SOCL. This shows that facebook has outperformed the social media ETF since it put in a higher low and began an uptrend in mid 2013.
Relative weakness is when the underlying secruity being studied is underperforming the security it is being compared to. The chart below shows the ratio of SPY/IWM on a weekly basis. This shows that since the year 2000, the S&P 500 has underperformed the Russell 2000.
Other Methods Besides Ratio Charting:
Another, more simple way to determine relative strength and weakness is by looking at the absolute performance of two charts side by side. For example, if SPY is up 5% for the year, but IWM is down 5% for the year, it is showing weakness relative to SPY. The ratio chart just makes it easier to visualize this relationship.