What is Relative Strength?
Also called price persistence, relative strength is the tendency of a security's price to follow the trend of an index like the S&P 500. It is a measure of momentum.
How Does Relative Strength Work?
To illustrate, let's assume the price of Company XYZ's stock has been consistently rising over the last six weeks. The stock was at $10 at the start of the six weeks; it is now at $18 -- an 80% increase. During the same period, the S&P 500 increased by 15%. If relative strength holds true, XYZ's stock price should continue to increase until it encounters a resistance line.
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Why Does Relative Strength Matter?
The basic idea behind relative strength is that if Company XYZ's shares have been increasing (or decreasing) over the last several weeks, the shares will likely continue on the same trend. Although relative strength can provide investors a reason to sit back and 'ride' a stock if it is heading up (or dump a stock if it is heading down), relative strength might also signal that a stock is becoming overpriced (or underpriced, if the trend is heading in the other direction). One reason for this is that relative strength is measured exclusively on historical performance and thus does not account for future performance.