Stocks Outperforming The Market

A stock is an "outperformer" when its returns are better than the benchmark return that it is being compared to. Typically, a benchmark is a broad based index but can also be a sector index or group of similar companies. We use the SPDR S&P 500 ETF (SPY) as our benchmark. The SPY is designed to track the S&P 500 stock market index.

To measure the stocks outperformance we need to make a relative comparison of the individual stock return to our benchmark over the same time period. You can look at a stock’s returns for a week, a month, or a year. We must include the increase in stock price as well as any dividends paid over this time period, and then compare it to the returns for the benchmark, in our case the SPY. If a stock's returns are more than the benchmark it is considered that the stock outperformed. We can also take it further by looking at the average daily returns in order to smooth out any one day big jump, we can also take the standard deviation(standard deviation is a way to measure a stocks normal volatility) of these returns into consideration to break apart a unit of risk.

So, for example if Stock A on average returned .5% per day ,and had a standard deviation of 2% then the ratio of return over standard deviation is .25%.

Let's compare Stock A to the benchmark. If the benchmark had the same average daily return of .5%, but its standard deviation was 4% then the ratio would only be .125%. As you can see it had more risk because it had higher standard deviation.



Therefore, Stock A would have outperformed our benchmark because you got more return for each unit of risk.

Traders will try to select winning stocks that have been performing better than the rest of the market to identify stocks with higher relative strength to others in the similar industry, and find industries and sectors that are in favor.

Traders can also easily identify stocks and sectors that are currently weak and out of favor when compared to the rest of the market, either to stay away from or might be undervalued.

Stocks that are relatively strong compared to a benchmark can point to positive momentum, where investment capital is flowing, while relatively weak stocks can point to companies or industries experiencing problems, and potential places to stay clear.

The goal of investing in individual stocks is to get greater returns than the market returns. If this was not possible you would be better off investing in a market index or mutual fund which is more diversified.

Long Short Strategy
Traders who believe a stock or basket of stocks can outperform the market would go long(buy and hold) on these stocks, and conversely, short stocks(a bet that a stock will drop) that the trader believes will underperform the benchmark or market. This would be referred to as "Long Short" strategies.

Long Stock Short Market Strategy
Also if a trader feels a stock may outperform the market but is feeling nervous about the overall market he or she can go long the stock and short the market index as a hedge against the market going down. This is a way of hedging the market risk by isolating it to the company specific risk.
So if the stock and market both go up and the stock outperforms, then the stock returns will exceed the loss of the hedge or short position.
If the market goes down but the stock doesn't decline as fast as the market then the gain on the hedge can exceed the loss of the long stock.

Of course, there is no perfect strategy and no way of knowing what will happen. The historic returns of a stock should only be used as guidance. Traders should or will often do further research into company, industry and economic news, company financials, and future prospects before initiating any risky positions.