Relative Volatility Index Strategy

Relative Volatility Index (RVI) Strategy – Returns, Statistics, Performance

One thing about the financial trading world is that traders are always looking for more tools to analyze the markets, and one such emerging tool is the Relative Volatility Index (RVI). What do you know about this tool and how to use it?

The Relative Volatility Index (RVI) is a technical indicator traders can use to determine the direction of price volatility. Created by Donald Dorsey, the indicator uses the standard deviation of high and low prices over a given period to calculate the direction of volatility. Higher readings indicate higher upside volatility, while lower values indicate more downside volatility.

In this post, we will take a look at everything you need to know about this indicator: what it is, how it works, and how you can improve your trading strategies with it. Let’s dive in!

Table of contents:

Key takeaways

  • The Relative Volatility Index (RVI) is a technical indicator traders can use to determine the direction of price volatility.
  • It is very similar to the RSI, but the RVI uses the standard deviation of the high and low prices.
  • We backtest a trading strategy.

What is the Relative Volatility Index (RVI)?

The Relative Volatility Index (RVI) is a technical indicator traders can use to determine the direction of price volatility. Created by Donald Dorsey, the indicator uses the standard deviation of high and low prices over a chosen period to calculate the direction of volatility.

It is very similar to the Relative Strength Indicator (RSI), but unlike the RSI which uses absolute prices in calculating the price strength, the RVI uses the standard deviation of the high and low prices.

The RVI values ranges from 0 to 100, with higher readings indicating higher upside volatility and lower values indicating more downside volatility. It, therefore, oscillated around the 50 level — values above 50 suggest a high volatility to the upside, while readings below 50 indicate a high volatility to the downside.

Values above 80 and below 20 are considered unstable and signal a potential market reversal.

What does the Relative Volatility Index (RVI) look like on a chart?

We coded the RVI in Amibroker, and below is an example of how a 10-day RVI looks like for the gold price:

Relative Volatility Index
Relative Volatility Index

How does the RVI differ from other volatility indicators?

The RVI differs from other volatility indicators in that it compares the magnitude of recent price changes with the overall price trend, thereby showing both the market strength and volatility direction.

Specifically, it measures the standard deviation of the high and low prices over a chosen period and uses that to track the direction of price volatility. This is unlike other volatility indicators like the ATR and standard deviation, which only measure the magnitude of volatility in the market but don’t show the direction of the volatility.

The RVI is similar to the RSI. But it measures volatility using standard deviations, unlike the RSI which measures price strength.

Relative Volatility Index (RVI trading strategy – rules, backtest, returns, and performance

We have explained the index to you, but the proof is always in the pudding, and the financial markets are no different. Let’s formulate some trading rules and put the indicator to the test.

We make the following trading rules (and we include the full Amibroker code for your convenience):

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When we employ these trading rules on the gold price (the ETF with the ticker code GLD), we get the following equity curve from its inception until today:

Relative Volatility Index strategy
Relative Volatility Index strategy

The exit rule is a time stop, and it works well for all stops above 2 days, thus less likely to be a result of chance and randomness.

The trading performance and statistics read like this:

  • The average gain per trade: 1.98%
  • The win rate is 72%
  • The average winner is bigger than the average loser
  • Max drawdown is 8%

Why is the RVI important for traders and investors?

The RVI is important for traders and investors because it shows how much volatility is in the market at any point in time, as well as the direction of that volatility. It uses the standard deviation of the high and low prices over a chosen period to measure the direction of price volatility.

Some traders use the indicator as a preliminary indicator to know whether to trade and in which direction to look for trading opportunities. Others use it to confirm the signals from other indicators and trading tools. Whichever way you use it, the RVI can improve your understanding of the market movement.

How is the RVI calculated?

The RVI is calculated like the RSI, except that the standard deviation of up and down periods is used rather than the absolute values. So, the RVI calculation consists of 2 steps: calculating the Relative Volatility (RV) and calculating the RVI from the RVI.

Step 1: Calculating the Relative Volatility (RV)

RV = Standard Deviation of Up Periods / Standard Deviation of Down Periods

Here’s what you do:

  • Identify the candlesticks that closed higher than the preceding one (up period) and those that closed lower than the preceding one (down period) within the period under study.
  • Find the standard deviation of the ‘up’ and ‘down’ candlesticks over the chosen period.
  • Divide the standard deviation of ‘up’ candlesticks by the standard deviation of ‘down’ candlesticks.

Step 2: Using the RV to calculate the RVI

RVI = 100 – 100/(1+RV)

What does a high RVI value indicate?

A high RVI value indicates that there is an increased volatility to the upside. Specifically, values above 50 are considered high upside volatility. The higher the RVI value, the more the upside volatility. But this relationship is up to a point where the market may be considered overbought and likely to reverse.

This overbought level is usually around the 80% level. However, the market doesn’t always reverse once it crosses above the 80% level — sometimes, the indicator would remain there and the market would keep rising.

What does a low RVI value indicate?

A low RVI value indicates that there is an increased volatility to the downside. Specifically, values below 50 and descending are considered low RVI, and they indicate a high downside volatility. The lower the RVI value, the more the downside volatility.

But this relationship is up to a point where the market may be considered oversold and likely to reverse. This oversold level is usually around the 20% level. However, the market doesn’t always reverse once it crosses below the 20% level, as the indicator may continue falling or stay flat below that level and the market would keep falling.

How can traders use the RVI to identify trends?

To use the RVI to identify trends, traders often use the centerline of the indicator as the reference point. This is the 50% level. When the indicator crosses above the 50 level and keeps rising, traders interpret it as an indication of an uptrend in the market. But when the indicator rises beyond the 80% level, traders become concerned about the stability of the uptrend and consider the market overbought (the upside move is overextended).

On the other hand, when the indicator crosses below the 50 level and keeps falling, traders interpret it as an indication of a downtrend in the market. However, the indicator falling below the 20% level raises concern about the stability of the downtrend, and traders consider the market oversold (the downside move is overextended).

Can the RVI help in predicting market reversals?

Yes, the RVI can help in predicting market reversals. In an uptrend, the indicator rising beyond the 80% level gives traders concern about the stability of the trend, and they consider the market overbought — that is, the upside move is overextended, and the market may reverse at any moment.

Likewise, in a down-trending market, when the indicator falls below the 20% level, traders become concerned about the stability of the downtrend and consider the market oversold. In other words, the downside move is overextended, and the market is likely to reverse.

How frequently should traders monitor the RVI?

How frequently a trader monitors the RVI depends on their trading style and the timeframe in which they do their analysis. A scalper who trades on the 1-min chart may have to monitor the RVI every minute, while a day trader who does their analysis on the hourly timeframe would have to monitor the indicator at most every 1 hour.

Likewise, swing traders and position traders would have to monitor the indicator on higher timeframes, and that could mean every 4 hours, every day, or every week, as the case may be.

What are the advantages of using the RVI in trading strategies?

The advantages of using the RVI in trading strategies are many. Here are some of them:

  • The indicator is based on the standard deviation of prices and, as such, tells you the level of volatility in the market.
  • It helps you to the direction of market volatility.
  • It tells you where the price is likely headed.
  • It tells you when the trend may be overextended and likely to reverse.
  • You can use it to find entry and exit levels.
  • It can easily be combined with other indicators or analysis tools.

What are the limitations of the Relative Volatility Index?

The limitations of the relative volatility index include:

  • It is based on past price data, so it can lag the price sometimes.
  • It cannot show what the market would do next with any certainty.
  • It is prone to whipsaws in a choppy market condition
  • It can give a lot of fake signals and thus, should not be used as a standalone indicator

Are there any alternative volatility indicators similar to the RVI?

Yes, there are alternative volatility indicators, such as the average true range, Bollinger bands, standard deviation, Twiggs Volatility Indicator, Chaikin Volatility Indicator, Volatility Index, and so on, but none of them is actually similar to the RVI.

While most other volatility indicators only indicate the level of volatility in the market, the RVI tells you both the level of market volatility and its direction.

How can traders interpret divergences between price and RVI?

To interpret the divergences between the price and the RVI, traders have to look at the corresponding swings made by the price and the indicator. As an oscillator — just like the RSI — the RVI swings up and down between 0 and 100, and these swings correspond with the price swings.

A divergence between the price swing and the indicator swing is said to occur when the price makes a higher swing high and the indicator makes a lower swing high and vice versa. Or, when the price makes a lower swing low and the indicator makes a higher swing low and vice versa. Traders interpret the former as a bearish divergence, signaling a potential bearish reversal, and the latter as a bullish divergence, signaling a potential bullish reversal.

Can the RVI be used in conjunction with other technical indicators?

Yes, the RVI can be used in conjunction with other technical indicators to get a better understanding of the stage of the market cycle. As a volatility indicator that also shows price momentum, the RVI can easily be combined with a moving average indicator that can show the longer-term trend in the market.

In this case, the moving average would show the trend, while the RVI can be used to know when the direction of price volatility and momentum changes to the trend direction after a pullback, providing an opportunity to ride the next impulse swing in the trend direction.

How can traders adjust RVI parameters to suit different trading styles?

Yes, traders can adjust RVI parameters to suit different trading styles because the indicator is highly dynamic and adapts to any timeframe the trader uses — it shows the market volatility relative to the timeframe used.

If a day trader wishes to use the indicator for day trading, they can set it up on the hourly or 15-minute timeframe (whichever one they prefer to do their analysis on), and the indicator will show the market volatility and trend based on that timeframe. The same applies to any other trading style.

What timeframes are suitable for analyzing the RVI?

Any timeframe can be suitable for analyzing the RVI. The timeframe of choice depends on the trader and their trading style. A swing trader may choose to do their analysis on the 4-hourly timeframe or the daily timeframe, while a day trader would choose to do their analysis on the hourly or 15-minute timeframe.

Similarly, a scalper would do his or her analysis on a still lower timeframe — the 5-minute or 1-minute timeframe. However, as with other technical indicators, the higher the timeframe, the more reliable the RVI signal, as there’s less noise in higher timeframes than in lower timeframes.

Can the RVI be applied to different financial instruments?

Yes, the RVI can be applied to different financial instruments, as long as the price data for the instrument is printed regularly. The RVI relies on price data, so once it is available, it can be used to compute the indicator’s line.

However, not all trading platforms have a built-in RVI indicator — for example, the popular Forex platform, MT4, doesn’t have the indicator. If the trading platform you are using doesn’t have it, you can get a custom-made RVI indicator for the platform.

How does the RVI react to sudden market movements?

How the RVI reacts to sudden market movements depends on the period used in the indicator’s settings. If a long period is used, the indicator line would be smoother and may not react fast to a sudden market movement.

But if the default 14-period setting is used, the indicator’s movement would be fast, and a sudden price movement would cause a spike in the indicator.

What historical data is required to calculate the RVI?

The only historical data required to calculate the RVI is the price data. The indicator uses the standard deviation of the up periods and down periods within the chosen period to calculate the relative volatility in the market, which is then converted to a range-bound index that moves between 0 and 100.

Are there any common misconceptions about the Relative Volatility Index?

Yes, there are a few common misconceptions about the relative volatility index. These are some of them:

  • The RSV measures the market strength: Some traders confuse the RVI with the RSI and think that the RVI measures market strength and momentum just like the RSI does. In reality, the RVI uses standard deviation to calculate price volatility.
  • It is a volume-based indicator: It’s easy to confuse the RVI with the Volume RSI and think it is a volume-based indicator. The RVI only uses the price data to calculate volatility in the market.
  • It can be used as a standalone indicator: While some may want to use the RVI as a standalone indicator, it is best to combine it with other indicators to better understand the stage of price movement.

How can traders avoid false signals when using the RVI?

To avoid false signals when using the RVI, traders should combine it with other indicators or price action analysis to better understand the market structure and the stage of price movement.

Another thing they can do is to not use the indicator on lower timeframes so as to reduce the effects of market noise. It may also be necessary to use a longer-period setting than the default 14-period setting.

What role does volume play in RVI analysis?

Volume does not play any role in RVI calculation, as the RVI is different from Volume RSI which uses up-period volume and down-period volume data. The RVI focuses only on price data, where it uses the standard deviation of the up and down periods.

However, the volume data can be combined with the RVI indicator when analyzing the market to better understand what’s happening in the market and get more reliable trading signals.

How can traders use the RVI to confirm trade entries and exits?

To use the RVI to confirm trade entries and exits, traders can combine the indicator with other indicators or price action analysis to formulate a robust trading strategy with clear entry and exit criteria.

For instance, a trader can decide to formulate a momentum-based trend-following strategy that aims to ride the impulse swings of any trending market. This strategy would try to enter the market when a pullback is over and the price is about to resume the trend. In this case, the trader can combine the RVI with a moving average indicator — the moving average would show the trend, and the RVI would follow the price swings and indicate when to enter a trade to ride the impulse swing and when to exit to avoid the next pullback.

What are some practical tips for beginners using the RVI?

Some practical tips for beginners using the RVI would go as follows:

  • Don’t trade with the RVI alone.
  • Trade only in the direction of the main trend and use the RVI to identify when to hop into the market to ride the next impulse wave.
  • Have a backtested strategy with positive expectancy before you put your money on the line.

How can traders stay updated on RVI-related developments and strategies?

To stay updated on RVI-related developments and strategies, traders can keep an eye on market news channels like Bloomberg, CNBC, and so on, as well as on forex websites like Forexfactory, Investing.com, therobusttrader.com, and quantifiedstrategies.com.

They can also read articles published by Donald Dorsey, the creator of the indicator, in the Technical Analysis of Stocks & Commodities magazine.

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