Option Investor
Educational Article

And The Verdict Is...

Printer friendly version

You didn't think I was going to just give the answer in the opening paragraph did you? I seem to remember reading somewhere that the journey is its own reward. GRIN In the case of our study on relative weakness in the Housing sector, I have certainly found that to be the case, as some of my initial expectations were tested during the process. Before we get started though, let's bring any newcomers up to speed. If you missed the first half of our discussion, you'll need to catch up at the following link.

And Now For Something Completely Different

Last time, based on the weakness we could clearly see in the chart of the Home Construction index ($DJUSHB), we probed several of the prominent stocks in the sector, looking for the weakest of the weak. I deliberately stayed away from looking at Relative Strength charts on our initial examination, so that hopefully we will see how relative strength or weakness presents itself in the standard price charts. This exercise should prove particularly useful to those of you without the ability to generate ratio charts like those available from Qcharts.

Fortunately for us, the $DJUSHB and the four stocks we looked at on Monday, really haven't moved much. That means the analysis we did a couple days ago should line up nicely with our continuing investigation tonight. So without further ado, let's get to the RS charts. Going in alphabetical order, CTX is first on the agenda.

Relative Strength Chart - CTX vs. $DJUSHB

While the price of CTX has continued to drift lower this week, we can see that the stock is continuing to strengthen relative to its sector as measured by the $DJUSHB. Over the short term, I don't like the downside in the stock due to the fact that its RS chart is climbing. And the longer term doesn't look much better for the bears, with the RS chart producing a higher low in October vs. that seen back in May. Clearly, this isn't the bastion of weakness that we're searching for. Next up is LEN, where we hope to find more conclusive weakness.

Relative Strength Chart - LEN vs. $DJUSHB

Hmmmm...that's looking even worse for the bears, now isn't it. A solid series of higher lows on the RS chart indicates that LEN is consistently gaining ground relative to the $DJUSHB index. LEN has given up $10 or 16% since the middle of October. That decline has brought the RS chart down to form a new higher low over the past week, which could very well lead to another rebound in the near term. If looking short LEN on a breakdown under the $50 level (major support and right where the stock closed on Wednesday), we need to see the RS chart violate the early November low (0.174) to confirm weakness. This is a potential candidate for weakness, but it certainly hasn't been proven yet. Continuing down the list, PHM is next on the docket.

Relative Strength Chart - PHM vs. $DJUSHB

PHM was definitely a leader to the downside during the August-September swoon, but since early October, the picture has changed significantly. Note that the RS chart put in a solid double-bottom near 0.137, and has been steadily recovering since then. The real test is coming up near the 0.155 level. Will the PHM RS chart remain rangebound or break out, confirming its apparent relative strength. There's another interesting clue here. While I haven't show the comparison here, I find it interesting that the RS chart rebounded from the level of the May lows, while the PHM price chart posted a lower low than in July, which itself was a lower low than seen in May. Put another way, the lower low in price was NOT confirmed by a lower low in relative strength. This is an example of bullish divergence, and if recognized at the time would have given added conviction for a bullish trade in PHM off the October lows.

Looking forward, we can use the PHM RS chart to gauge the strength of the stock in the near term as it approaches resistance. If the RS chart once again fails at resistance, that will be an early clue that PHM might be an early bearish candidate. On the other hand, if the RS chart continues north through the 0.155 level, that will be a clear breakout and would likely indicate further price strength (relative to the $DJUSHB) ahead. Well, that's three for three. Of the three stocks we've looked at, I don't see any significant relative weakness that makes me want to launch into a bearish trade. Let's hope our last candidate, RYL has more to offer.

Relative Strength Chart - RYL vs. $DJUSHB

Aaahhh, now that's better. Note how the RS chart actually gave us a lower low in October than what was seen in July, which is far below the low posted in May (not shown). While the RS chart put in a double-top near 0.137 in early November, price failed to get anywhere near the July top, putting in a lower high. The opposite of the divergence seen in PHM, this is a clear case of bearish divergence between price and RS, indicating last week that RYL was likely due for a fall.

After the sharp slide of the past week, RYL is basing right now near the $36 level, which is a significant level of support, as we mentioned on Monday. A breakdown below that level likely leads the stock to test its early October lows near $31, and that would be our next opportunity to make a meaningful RS observation. I would want to see whether the RS chart finds support near 0.1225 (the site of the July low) as a rebound from there could set up the potential for a Head & Shoulder bottom. That's right, we can apply chart patter recognition to RS charts, just like we do to standard price charts. If that level failed to provide support, then we would need to look for RS support near the October lows. If that level also failed to provide support, then I would be very surprised to see the $31 level hold as support, meaning that the stock would likely see another leg down.

While I'm less than gratified by what I found in these RS charts, I would have to rank the stocks as follows. RYL is clearly the weakest of the four, followed by LEN. Note that the weakness in LEN is near-term, as the long-term picture of relative strength (due to the higher lows) is very much intact for now. Between CTX and PHM, I think it is a toss-up as to which is the strongest on a RS basis. But without a doubt, CTX and PHM would not get my attention for a bearish trade, based on what I see here.

I mentioned on Monday that where this sort of study can really come in handy is in placing a Relative Strength Spread. Simply put, it would involve buying calls on the strongest of the stocks and buying puts on the weakest. The way it works is that if the sector strengthens, the gains from our calls (on the strong stock) should outpace the loss on our puts (on the weak stock). Conversely, if the overall sector declines, then the puts (on the weak stock) should appreciate faster than the calls (on the strong stock) lose value.

Applying this concept to the four stocks we reviewed in this discussion, I would be looking to buy puts on RYL and calls on CTX. Needless to say, after putting on this sort of trade, you need to closely monitor the RS charts to make sure that the trend of relative strength and weakness that you observed at the outset remains in effect. I don't necessarily think this is a good strategy in the Housing sector right now, as I'm more inclined to focus on the downside in keeping with my bearish bias on the sector. So, my preference would be to look to the bearish side on the likes of RYL and perhaps LEN.

With that being said, I would be hesitant to initiate new positions, even on these weaklings, at current levels. Note that both LEN and RYL are right at pivotal support levels. The better approach would be to wait for the next failed rally to enter put positions at a higher level, assuming the RS charts continue to send us the same signals at that time.

Hopefully this extension of our discussion on Relative Strength gives you a better idea of how to look at and interpret a stock's relative strength chart and correlate it back to price action.

I really wanted to go into further detail on the subject of the RS spread today, but as usual, I'm way over my space allotment. If you'd like me to cover that strategy in greater detail, be sure to drop me an email to that effect and we'll delve deeper into the topic next week.

Have a great week!


Options 101 Archives