PART I -- USING THE RELATIVE STRENGTH LINE TO FIND SWING TRADING OPPORTUNITIES

In technical analysis, sometimes the simplest tools are the most powerful. One of the indicators to which I pay detailed attention is also one of the most basic in the swing trader's tool kit: the relative strength line. If you have not already incorporated this instrument in your analysis, I strongly suggest you do so.

The stock I have selected to illustrate relative strength is Applera (ABI, $18.05) a biotech company. In this issue I want to show how a strength line is calculated; next I want you to see how trendlines on the underlying stock, in conjunction with trendlines on the relative strength line, can be used to spot opportunities. Finally, I want to point out the importance of relative strength divergences as one of the first clues a stock may be changing trend.

At Stockcharts.com, the website I use for the charts in this newsletter, the relative strength line is called "Price Relative to the $SPX." This indicator compares a stock's relative strength to the overall "market" or S&P 500. If the swing trader desires, the comparison could be made to another biotech stock such as Genetech (DNA, $51.83) or the overall Biotech Index ($BTK, 525.00).

Stockcharts automatically computes the relative strength line, but it is helpful to understand the underlying calculation. On August 2nd, ABI hit an intra-day peak of $20.98 and closed at $20.86. On that same day, the S&P 500 ended the session at 1106.82.84. The calculation to find the relative strength on that date is:

20.86 / 1106.82 = .01885

This number has been rounded and is found on the right hand scale of the stockcharts.com relative strength panel. On Thursday, September 23rd, the parallel numbers were:

18.25 / 1108.36 = .01646

Stockcharts has rounded this to .0165. Note that between early August and late September the S&P was up very slightly, but the price of ABI declined by nearly 10%. The decline in the ratio from .018 to .016 shows that the stock has lost relative strength. In other words, ABI has been far weaker than the overall S&P index during the period measured.

So what makes me put ABI on a watch list for stocks to go long on? First, the weekly chart shows that ABI has found support at $18 four separate times in the last year and a half. This support was tested in May 2003, April and May 2004 and again in September 2004. Note that the recent low was hit on Wednesday, September 15th at $18.12. Between that date and Thursday, September 23rd, the S&P fell about 20 points, but ABI has held as steady as a rock.

Second, note the behavior of the relative strength line during the last several days. As ABI has held steady, the relative strength has entered a small uptrend marked by rising peaks and rising valleys. This is called bullish relative strength divergence. As the price of ABI has held steady, its relative strength to the S&P 500 is improving. This change in relative strength could be an early clue the stock is about to change trend.

Downtrend lines can of course be drawn on a price chart, but they are equally helpful on the relative strength chart. Many times the downtrend line in relative strength will be penetrated before the downtrend line on the price chart and when this happens it is a leading indicator of a breakout. Both downtrends could be broken by only a minor rally in the shares. The likelihood, however, is that the relative strength line will give its warning before the trendline break on the price chart.

Also note the surge of volume in the stock over the last several days. Since the stock has found a floor at $18, four of the last eight days have seen well above double or more the normal daily average of shares traded. Finally observe the stochastics and MACD indicators. Both are showing the bullish divergence evident in the relative strength line.

So far the shares of ABI are only a strong watch. It takes a signal on the price chart, not on an indicator, to give a buy signal. However, the change in the relative strength pattern provides a clue ABI may again find support at $18 as it has done several times in the past. Next week I will show how the relative strength line itself can be analyzed technically using support, resistance and price patterns. This analysis will often provide a leading indicator of how the price of a stock will perform.

PART II -- SUPPORT AND RESISTANCE ON THE RELATIVE STRENGTH LINE
Traders can also profitably analyze the relative strength line with two other technical concepts: support and resistance and "price" patterns. Just as you can draw support and resistance lines on a stock price chart, you can also do so for the relative strength line. When analyzing a stock, traders can derive patterns by combining trendlines with support and resistance lines. That is also true when interpreting the relative strength line where a variety of ascending, descending and symmetrical triangles form. 

When analyzing a price chart, triangle patterns can give advance warning about the future direction a stock might take. Descending triangles have a bearish bias, while ascending triangles often break out to the upside. Symmetrical triangles are hard to judge, but the bias of this pattern can be observed by noting which of the two lines of the triangle is longer.

During a period of market correction, one of the best ways I know to spot future leaders is to look for stocks whose relative strength line remains in an uptrend. When strength returns to the market, check to see if the relative strength line then breaks resistance. During a pullback, a particular stock's price may decline along with the overall market. However, if the relative strength line trends higher and breaks resistance, then it tells the swing trader that the stock is likely to outperform the S&P.

The stock I have selected to illustrate these points is Cognizant (CTSH), a software developer. In late July, Cognizant hit a high of $27.93. The stock then declined with the rest of the market to a low of $24.02 in mid-August. By early September, CTSH had broken through $27.93 resistance and had completed an ascending triangle, stalling at $29.70, just below psychological resistance at $30.

The shares then drifted lower, finding support at $27.94, a penny above the previous resistance of $27.93. CTSH was a classic example of the principle that old resistance, when penetrated, becomes new support. On Wednesday, September 29th, CTSH broke its minor downtrend line and pierced psychological resistance on Thursday, closing the session at $30.50.

Now look closely at the relative strength line. First, note its persistent uptrend from mid-August to early September. This was a period when the S&P rallied from 1060 to 1130. The relative strength line shows that CTSH was a very strong stock in a strong market. Beginning September 13th, the relative strength line declined slightly, yet it still held above its uptrend line. When combined with the uptrend line, a symmetrical triangle emerged. Since the uptrend line is longer than the downtrend line, the bias was toward an eventual upside breakout. 

Next, a horizontal resistance line is drawn above the September 13th peak. Note that the downtrend and resistance lines were broken by the rally of Wednesday, September 29th. This relative strength breakout was confirmed on Thursday when CTSH broke above an important psychological barrier at $30. Attention to the message of the relative strength line would have given the swing trader technical "encouragement" to take a position Thursday morning as the stock's price moved through $30.

When working with the relative strength line, swing traders should identify trendlines, support, resistance and price patterns. Look for breakouts above resistance to identify stocks that are very likely to exceed resistance in price. When used in this way, relative strength is a simple tool, but also a very powerful one.

Good trading!

Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader

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