The Role of Relative Strength in William O'Neil's System: A Practical Guide

In William O'Neil's CAN SLIM methodology, the "L" for Leader or Laggard is a important component that is often misunderstood by novice traders. O'Neil's research showed that the best-performing stocks are the ones that are already outperforming the market before they make their big move. This concept of relative strength is a cornerstone of his system, and for the experienced trader, it is a effective tool for identifying stocks with the potential for explosive growth.

What is Relative Strength?

Relative strength is a measure of a stock's price performance compared to the overall market. It is not to be confused with the Relative Strength Index (RSI), which is a momentum oscillator. The relative strength that O'Neil focused on is a simple comparison of a stock's price action to a benchmark index, such as the S&P 500.

A stock with high relative strength is one that is performing better than the market. It is a stock that is going up more than the market in an uptrend, and going down less than the market in a downtrend. These are the market leaders, the stocks that are in high demand from institutional investors.

Why is Relative Strength Important?

Relative strength is important because it is a sign of a stock's underlying health. A stock that is outperforming the market is a stock that has strong fundamentals, a new product or service, or some other catalyst that is driving its growth. It is a stock that is in favor with the big money, and that is the kind of stock you want to own.

O'Neil's research showed that the vast majority of super-stocks had a high relative strength rating before they made their big move. He found that the best-performing stocks had a relative strength rating of 80 or higher, which means they were outperforming 80% of all other stocks. This is a effective filter that can help you to narrow down your focus to the most promising candidates.

How to Measure Relative Strength

There are a number of ways to measure relative strength. The simplest way is to look at a stock's price chart and compare it to a chart of the S&P 500. Is the stock making new highs while the market is still in a correction? Is the stock holding up better than the market during a pullback? These are all signs of high relative strength.

Many charting software packages also have a relative strength indicator that you can plot on your charts. This indicator will typically show a line that represents the ratio of the stock's price to the S&P 500. A rising line indicates that the stock is outperforming the market, while a falling line indicates that it is underperforming.

Another way to measure relative strength is to use a relative strength rating, such as the one provided by Investor's Business Daily (IBD). IBD's RS Rating ranks all stocks from 1 to 99, with 99 being the best. O'Neil recommended focusing on stocks with an RS Rating of 80 or higher.

A Word of Caution

While relative strength is a effective tool, it is not a magic bullet. A stock with a high relative strength rating can still fail. It is important to use relative strength in conjunction with the other components of the CAN SLIM system. A stock with a high RS Rating but weak earnings growth is not a good candidate.

It is also important to be aware of the overall market trend. In a bear market, even the strongest stocks can get pulled down. It is best to be in cash during a bear market and wait for a new uptrend to begin before you start buying stocks with high relative strength.

By incorporating relative strength into your stock selection process, you can significantly improve your odds of success. It is a effective way to identify the market's true leaders and to avoid the laggards. By focusing on the strongest stocks in a rising market, you can position yourself for explosive gains.