Relative value is a way of measuring the relative worth between two items. In relative value trading, you compare the price movements of one asset to those of another. The relative movement between any given pair can then be used as a gauge for deciding when it might be time to buy or sell an asset relative to another. Relative values can also be used in tandem with relative value strategies.
The technique relies on a historic relationship between investments and assumes that relative values will revert to a mean over time. Relative value is therefore often used as a longer-term trading strategy where several weeks or even months could pass before any notable changes in relative values are observed.
Why Does It Matter
A relative value is a good way for traders to spot the relative strength of one market compared with another and can be particularly beneficial when trading stock indices where price movements are often not dissimilar across the board.
Relative value is also important because it makes it possible to invest in assets that may not otherwise be considered as they may be relatively cheap relative to other assets. For instance, the relative value may be used to trade crude oil relative to natural gas even though the relative values of both commodities may move independently in different directions.
When to Use It
The relative value of different assets can often be seen as a good predictor for future returns and performance relative to another asset (because it will revert to an equilibrium point over time).
The relative strength index (RSI) is also used by traders as a way of predicting whether a market is overbought or oversold. So relative values can be a good way for traders to forecast future price movements and decide when it is a good opportunity to either buy or sell relative values.
In terms of relative value trading, the relative strength index is particularly useful as it gives traders an indication as to which asset class may strengthen relative to another.
How to Calculate It
The relative value of asset A relative to asset B is measured as the ratio of D/S, where D is the number of days that asset A has outperformed relative to asset B and S is the number of days that asset A has underperformed relative to asset B.
Relative Value = (D/S)
For example: if asset A outperforms relative to asset B for 40 days and underperforms relative to asset B for 30 days, the relative strength is 75%.
Advantage and Disadvantage
The relative value of an asset relative to another can be useful as a way of spotting possible opportunities with less popular investments. So using relative values can help spot relative strength and relative weakness in the market.
The relative value method is particularly useful for investors who are looking at commodity prices as it can help them identify relative weakness or relative strength between two commodities, which may not otherwise be picked up by other means.
However, relative value trading also has some disadvantages as there is no guarantee that past relative performances will be repeated in the future. The relative value method is also only reliable when used over longer periods of time (such as months or years). So relative values can change over shorter timescales and may not always provide traders with the most relevant information for day-to-day trading.
There are several other relative value calculations that can be used to predict relative strength and relative weakness, all of which use a ratio or some form of relative performance.
For example, the relative momentum indicator is calculated using the formula:
The Bottom Line
Relative value is a relative measure of the relative strength of an asset relative to another. This technique can be useful for longer-term relative value trading strategies as it allows investors to see which assets are relatively strong or weak relative to other assets in order to form investment decisions.
A relative value can be calculated by dividing the number of days that an asset leads relative to another by the number of days that it lags relative to another.
The relative strength index (RSI) is also useful when trading relative values as it can give traders an indication as to which asset class may strengthen relative to the other.
However, relative value trading does have some disadvantages, in that there is no guarantee that past relative performances will be repeated in the future. It is also only reliable when used over longer periods of time (such as months or years) and may not provide traders with relevant information for day-to-day trading.
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.