Above is a 60-minute chart of IWM, and in the lower pane I have the ratio line comparing IWM to SPY. This is a great example of how the ratio line can often act as a leading indicator, tipping off potential moves before price makes them obvious.
Let’s start with point A. At this point on the chart, the ratio line had already broken down to a new swing low even though price had not yet done so. On the surface, IWM still looked relatively stable, but under the hood it was already starting to underperform the broader market. Shortly after that breakdown in the ratio line, price gapped lower and then proceeded to trend down over the course of the following week. The weakness was signaled in advance by the ratio line, long before most traders would have reacted to price alone.
Now look at point B. Here we see the opposite scenario. The ratio line broke out to a new swing high well before price followed. I’ve drawn vertical dashed lines so it’s easy to see where price was at the exact moment the ratio line was already breaking out. While price still appeared range bound, relative strength was quietly improving. Not long after, price exploded to the upside. Once again, the ratio line led the move and gave an early heads up that conditions were shifting.
Now let’s fast forward to where we are now at point C. A few days ago, the ratio line once again broke down to a new swing low, but price has not yet confirmed it. This divergence suggests pending weakness. It doesn’t guarantee that price must move lower, and it certainly doesn’t tell us when, but it does tilt the odds in favor of the bears.
From here, what matters most is confirmation. If we start to see key support levels taken out in the coming days, I would expect price to eventually follow the ratio line lower, just as it has in the past. This is exactly why I rely so heavily on relative strength. It doesn’t replace price, but it often whispers the story before price shouts it.
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