Tuesday, November 24, 2009

Comparing Apples to What?

In continuing with the groundwork laid in yesterday's introduction of relative performance, I want to highlight various methods I've used to determine the relative strength of two securities. Suppose I'm considering a trade on an individual company such as Apple Inc. (AAPL). The first consideration is deciding what to compare it to. The three most common comparisons are as follows: Stock to Market Index, Stock to Sector, Stock to Stock. Let's expand on each one.

Stock to Market Index

Since the majority of traders use the S&P 500 Index as the benchmark for market performance, it makes sense to compare the SPX to AAPL to ascertain whether AAPL is outperforming (exhibiting rel. strength) or under performing (exhibiting rel. weakness). The ideal bullish scenario would be AAPL outperforming the SPX. If you preferred to use the Dow Jones Industrial Average or Nasdaq Composite, you could obviously modify which market index you use.

Stock to Sector

Just as I'd like to see AAPL outperforming the SPX, I'd also prefer that it was outperforming the technology sector. If you're unaware of how to chart a sector, you can use the Select Sector SPDRs which can be found on http://sectorspdr.com/. To borrow a commonly cited phrase from an obnoxious market pundit, I'm seeking the "best of breed". Not necessarily from a fundamental perspective, but rather from a relative performance perspective. If AAPL is indeed outperforming its sector than one would think it has a better chance of continuing to increase in value vs. if it were under performing its sector.

Stock to Stock

I've seen two approaches used in choosing which stock to use in the comparison. The first approach is to pick one of the stock's competitors within the same sector. The other approach would be to simply choose another stock you're considering buying in an attempt to identify which one is relatively stronger. In the case of AAPL, perhaps I could use GOOG if I wanted to choose one in the same sector. If, on the other hand, I was also considering a bullish trade on Exxon Mobil Corp. (XOM), there's nothing to say I couldn't use it in comparison to AAPL.

Whether we use one or all of the aforementioned comparisons, the bottom line is we're trying to build a bullish (or bearish) case on the stock in consideration for a directional trade. If AAPL is exhibiting relative strength vs. the broader market, the tech sector, and other competitors, we've got a much stronger thesis for selling put spreads or entering some other type of bullish trade.

Next time we'll explore the various tools/indicators that can be used to actually perform the analysis.