Most traders will spend hours poring over chart patterns on individual stocks and virtually no time at all asking the much simpler question of whether or not the stock is actually outperforming the market. Relative strength answers that question and is one of the best filters you can use to determine which setups are worth your money.

First a quick clarification as the names are confusing. Relative strength is not the same as the Relative Strength Index (RSI). The RSI measures the rate of change of a stock’s own price over a period of time. Relative strength is the comparison of one stock’s performance to something else, most commonly a benchmark such as the S&P 500 or the sector ETF. They're similar in name but they're answering two completely different questions.

The concept is straightforward. If the S&P 500 is up 4% over the last two months and a stock is up 15%, that stock has strong relative strength. If the stock is up only 1% in that same period it's lagging (even if the price is up). A stock that is rising less than the market is not really leading anything and the money is clearly going somewhere else.

The easiest way to see it on a chart is the relative strength line. You take the stock price and divide it by the index price and plot that as a line. If the line is going up the stock is outperforming. If the line is going down the stock is underperforming. Most charting platforms will allow you to plot a ratio or a comparison chart of the stock against an index (SPY for instance). You don't need any maths at all, just a ratio.

Why does this matter for swing trading? Because leaders tend to keep leading (at least for a while). The stocks that do well when the market is in a pullback are often the first to break out when the market turns. The big institutions build their positions over weeks and months and that consistent buying is reflected in the relative strength. If you're looking at the stocks with the best relative strength you're essentially putting your trades in line with where the big money is already going.

One of the most useful indicators is a stock that is holding its own whilst the market is in a downtrend. If the S&P 500 is down 3% over a few days and one of your watchlist stocks is only down half a percent or is flat, that tells you that there are buyers in that stock. When the market comes to a halt that stock is often in a good position to be the first to move. On the other hand a stock that falls significantly more than the market on a down day is clearly showing weakness and you would typically want to avoid it or look at it from the short side.

Another one to keep an eye on is the Relative Strength line making a new high prior to the price. If the RS line is making a new high and the price is still in a consolidation phase then that's a strong indication that the stock is outperforming in the background and is likely to break out at some point. It's not a sure thing by any means but it does add a lot of credibility to a set up that's already looking pretty good on the price chart.

You can also use relative strength to rank your watchlist. Select a time period (say the last 1, 3 and 6 months) and compare each stock’s % gain to the index over that same period. The names at the top of the list are your leaders. Spend most of your time looking at those and be very sceptical of anything near the bottom regardless of how good the chart pattern looks in isolation. A fairly attractive bull flag on a stock that's been lagging the market for months is a much weaker proposition than the same flag on a stock that's been in the lead.

Sector context is also relevant here. A stock can appear strong versus the S&P 500 simply because the entire sector is hot. You can see whether it's a genuine leader in the sector or just riding the wave by comparing it to its sector ETF. The best setups will show strength at both levels i.e. a strong sector and the stock outperforming within that sector.

There are some caveats to be aware of. Relative strength is a lagging indicator so a leader can very quickly lose its edge after a big run, particularly around earnings or when the market rotates into other sectors. A stock that is extremely extended above its moving averages is a terrible entry point even if its relative strength is very good as you'd be chasing. The way to do it is to use relative strength to pick the things to watch, then use your normal entry rules (a pullback to a moving average or a breakout on volume) to determine when to get in.

A good habit is to do this once a week. Go through your watchlist against the index, move the leaders to the top and drop the laggards. Over time you end up with a list which is naturally populated with the best names in the market and it makes it far easier to find good setups.