Trading with the Relative volatility index
When it comes to trading the price of a security, there is no dearth to the number of indicators that one could use. No matter what name you give an indicator, they primarily fall into of the main categories such as trend, momentum or volatility.
Table Of Contents:
- Trading with the Relative volatility index
- Relative Volatility Index Indicator
- What is volatility in the financial markets?
- What is the relative volatility Index?
- How is the relative volatility index calculated?
- Trading with the relative volatility index
- Using the relative volatility index with Donchian channels
- Trading the trend with RVI
- Trading with the relative volatility index - Conclusion
The relative volatility index is a volatility indicator. It belongs to the family of oscillators and is used to measure the volatility of the price of the security to which it is applied to.
The relative volatility index is primarily used by day traders and in the stock markets. But you can also apply the indicator to just about any market that you want to trade. As the name suggests, the relative volatility index or the RVI measures the volatility in the security.
Do not confuse the name RVI as the relative vigor index, which is a completely different indicator. The relative volatility index measures the relative volatility of the price compared to the lookback period. The typical lookback period is set to 14 periods.
When it comes to understanding price action, trends are established initially by rising volatility. Volatility can of course occur even when the markets are in a sideways range. Still, understanding the volatility gives you a better idea on the security that is being traded.
As volatility rises, it eventually leads into momentum building up. Therefore, the relative volatility index is ideally used by trend traders.
One might argue that the relative volatility index can be replaced with the average true range indicator or the relative strength index indicator for example. Note that these are completely different technical indicators and measure something very different.
They certainly do not measure volatility.
If you want to use the relative volatility index properly, you should first have an understanding of what volatility is all about.
What is volatility in the financial markets?
Volatility in the financial markets is a measure of the range and the speed of change in the price of a security. Volatility gives you the ability to understand the risk associated with the security that you are analyzing.
higher volatile securities are expected to carry higher risks. When risks are higher, the prospects of making higher rewards are also around the corner.
Volatility is usually mentioned in the markets during economic turbulence. Stocks for example turn volatile, as they adjust to the new and incoming data. Typically, a security is said to be volatility when its value can change significantly during a period.
To measure volatility, the standard deviation is used. Standard deviation is just a statistical figure widely used in science and in finance. The standard deviation measures the level of dispersion in a data set in relation to the mean values.
To rephrase the above in simple English, standard deviation measures how far or how wide prices can rise or fall, in relation to the mean prices. Securities that tend to exhibit higher standard deviation are said to be more volatile compared to securities that do not show high levels of standard deviation.
Volatility is important because it allows you to take advantage of the price action. It gives lots of trading opportunities for the day trader. Volatility goes by different names. For example, in stock market terminology, the term beta is widely used.
Beta, in the stock markets is nothing but the level of volatility relative to the S&P500 index. When a stock is more volatile than the standard benchmark index, it is said to have a high beta.
Conversely, when a stock has a low beta, it is less prone to be volatility. As a general rule of thumb traders prefer stocks with higher volatility due to the numerous trading opportunities that it creates.
Thus, as you can see, volatility and standard deviation go hand in hand. They are essential in understanding how volatile or active a security can be. To measure this, traders use the relative volatility index to understand the levels of volatility in the market.
Quite often, traders confuse volatility with momentum. These are two completely different concepts. Momentum simply measures the rate of change in the price of a security. When the trends are strong, momentum increases and when trends are weak, momentum is seen easing.
Just like the volatility factor, momentum is not a directional indicator. It only tells you how fast or slow the price of a security is changing.
Thus, when you use the relative volatility index you are basically measuring how active the security is. Based on this information, you can create a number of trading strategies or devise methods to understand price action.
What is the relative volatility Index?
The Relative Volatility index is a technical indicator that was designed by Donald Dorsey. It is meant to work as a confirming indicator. By a confirming indicator, it is one of those indicators that is used to confirm the direction of the volatility.
Visually, the relative volatility index looks similar to that of the relative strength index or the RSI indicator. This is but expected because the indicator sits in the sub-window and works as an oscillator as any momentum or volatility indicator would behave.
The key differentiating factor of the relative volatility index is that it uses the standard deviation values for the period that the indicator is set to. The standard deviation is derived from a mathematical formula which measures the volatility of the prices.
Thus, an indicator that is designed to measure the volatility in the security over a period of time displays the output as an oscillator. The relative volatility index oscillators between fixed values of 0 and 100.
Some traders view the relative volatility index as a measure of the market strength. Because prices are driven by volatility, this is an indicator that can be used in the short term markets. Trends are often driven by volatility and in this aspect, the RVI offers some unique insights into the markets for traders.
When Dorsey designed the relative volatility index, he understood that there was no single holy grail indicator. As such, the RVI needs to be used in conjunction with other technical indicators to confirm the larger market moves.
Just as with any oscillator, buy and sell signals are based on how the indicator behaves around the fixed levels. The RVI allows traders to clearly see when the volatility is falling. This allows them to judge the best time to buy the dips in a rally or the rallies in a decline.
How is the relative volatility index calculated?
The calculation for the relative volatility index is very simple. The indicator makes use of the standard settings of just a look back period. The lookback period basically outlines the number of periods in the past to look back to, in order to calculate the volatility in the security.
Below is an example of the relative volatility index on a security.
Relative Volatility index
The general setting for using the relative volatility index is a 14-period lookback. But you can adjust the parameters to suit your own requirements. Just remember that using a setting that is too small can make the indicator very reactive, while setting a longer lookback period can make it less reactive to the price volatility.
The default for the standard deviation is usually 10. But again, these values can be changed depending on one’s preference for the indicator and the markets that they are trading.
The formula for the relative volatility index is based on the difference between the standard deviation values from the previous levels compared to the current levels. A smoothing factor is used in order to smooth out the values and to give a certain smooth curve to the output.
Standard deviation is a readily available tool in the markets. In fact, there are technical indicators that simply measure the standard deviation of a security. The RVI can simply take the values from the standard deviation index and apply towards its own calculations.
The relative volatility index oscillators from 0 to 100, making the 50-level a key level of interest in the indicator. The general buy and sell signals are based on the crossing of the 50-level which can indicate rising and falling momentum.
In some trading platforms, the relative volatility index is plotted around values of 0 and 100 with the overbought and the oversold levels set to 80 and 20. This makes the oscillator’s settings somewhat similar to the Stochastics oscillator which also oscillates around the 80 and 20 levels, or the relative strength index indicator as well.
The way the relative volatility index behaves is nothing different from other oscillators that one would more commonly use. For example, the peaks and troughs formed in the relative volatility index is pretty much the same as what you would expect when using the relative strength index or the RSI indicator.
The same concepts applied to using an oscillator also apply to the relative volatility index. This includes, the buy and sell signals based on the crossing of the 50-level and of course, divergences based on the highs and the lows comparing to that of the price.
One of the advantages of the relative volatility index is that it can be applied to any market time frame. Therefore, this is a versatile indicator that can be used both for swing trading and short term intraday trading of the markets as well.
The indicator is not that widely available among all charting platforms. You will most likely find the relative volatility index on stock trading platforms as the indicator isn’t that widely used in the forex markets.
Depending on what sources you read, there are various examples of the Relative volatility index. Typically, the general trend is that when the RVI is above 50, it is seen as volatility being bullish. But when the relative volatility index falls below 50, it signals that the volatility is bearish.
However, this argument does not hold true due to the fact, that the RVI is not a directional indicator. Still, many traders tend to make this mistake.
Typically, it is recommended to use the RVI more of a confirmation tool rather than as an indicator that should be used in isolation.
Trading with the relative volatility index
There are various rules of trading using the relative volatility index. For starters, since it oscillates between 0 and 100, the general perception is to mark the 80 and the 20 levels as the overbought and the oversold levels in the indicator.
What this means is that if the indicator is trading near the overbought levels of 80 and above, it could suggest that volatility would fall. However, note that just because the indicator is at the 80 level doesn’t mean that volatility must have to fall.
There are instances when the indicator has maintained its level at or close to the 80 level for prolonged periods of time. One should remember that the relative volatility index basically derives the values from the volatility in the security. Therefore, price forms the primary aspect of the relative volatility index.
Another buy and sell signal is taken when the indicator crosses the 50-level. The markets are said to be bullish if the relative volatility index is above 50-level. This means that the market volatility is rising in a bullish market.
Similarly, when the relative volatility index falls below the 50-level it means that the volatility is falling. Note that relative volatility index is not a directional indicator. It only shows the rising and the falling volatility in the prices.
The RVI does not look at the trends. Which is why you would need to have other indicators to confirm the trends and you cannot just trade based off the relative volatility index.
An example below will illustrate the usage of the relative volatility index. In the chart below, we are looking at the stock price of AAPL. Here, we also apply the 200 day and the 50 day moving average indicator. The two moving averages depict if the markets are bullish or bearish.
Relative volatility index with moving averages
Lastly, we also use the relative volatility index. You will see the vertical levels that are marked on the charts. These lines show the periods when the volatility has been falling (below 50) and when volatility is rising (above 50).
Now by combining the trends and the volatility, you can see how the relative volatility index measures the rising and the falling volatility in the price of a security.
The above chart illustrates the benefits of using the RVI alongside other indicators to get a better idea of what price is doing. We use the moving average indicators as a way to measure or understand the trends in the markets.
Volatility remains the same regardless of a bullish or the bearish markets. Now that we have a good understanding of what the relative volatility index is all about, let’s look at some trading strategies that you can build based on the RVI as the core indicator in a trading system.
Using the relative volatility index with Donchian channels
We start off with using the Donchian channels and the relative volatility index. This is because, the Donchian channels make for an ideal choice of an indicator as it measures the high and low over a look back period.
By combining the highs and lows in the price and the momentum indicator, it is easy to determine the trends. The Donchian channel also acts as a direction indicator as it slopes up and down depending on the lower highs or lower lows being formed in price.
Thus, a simple but an effective trading strategy can be devised that makes use of the Donchian channels and the relative volatility index. Here, the Donchian channel’s high and low prices act as an indicator of the trend. Signals are taken from the relative volatility index to validate and to enter the market.
The chart below shows how the buy and sell signals are generated.
Relative Volatility Index with Donchian Channels
The first area marked by the vertical lines shows the buy signal that was triggered by the Relative Volatility index. Following this, we can place a long order after the previous high has been breached.
You can see that after price breaks past the previous high from the Donchian channel, a steady uptrend was formed. Price continues to rally until we see the next sell signal. In this instance, you can see that the sell signal is still developing.
But upon price breaking the low of the Donchian channel, we can expect to see price action moving lower and reversing direction of the trade.
The above simple but effective trading strategy can generate some good trend following trading signals. To avoid the false signals, you can wait for the relative volatility index to first make a peak and then pullback.
Following this, as long as price remains above or below the 50-level and as long as it is in the direction of the trend, you can expect to see price action maintaining the trend at a steady pace.
Trading the trend with RVI
Another simple method of using the Relative volatility index is by simply using the moving average bullish and bearish crossover. In this method, we simply keep adding to positions as and when the RVI breaks outs above 80 and then retraces.
One of the benefits of this method is that the trading system gives you enough time to react. Volatility does not rise and disappear within a few sessions. Therefore, depending on the bullish or the bearish positioning of the moving averages, you can simply keep adding to positions and lock in good profits.
The chart below gives a bullish example. Here, we make use of the 20 and 9 period exponential moving average. Using the RVI, we buy every time the index moves above 80 and then retreats.
Using RVI and Moving Averages
The same concept can be applied to when the markets are falling. However, it is important to note that this strategy tends to work best only in bullish markets. Therefore, it is not surprising that the RVI is one of the most commonly used indicators when it comes to day trading the stock markets.
Trading with the relative volatility index - Conclusion
In conclusion, the relative volatility index is a simple but an efficient market indicator that is used to measure the rise and fall in the volatility of a security. The relative volatility index is widely used in the stock and the futures markets, but it can also be applied to the forex markets as well.
The simplicity of this indicator is based on the fact that the RVI measures volatility based on the standard deviation.
As a result, this gives the trader an accurate view of the volatility of the security that they are trading.
Because the relative volatility index sits in the sub-window of the chart, it behaves in the same way as most oscillators do. Therefore, the relative volatility index can also signal different levels of volatility in the market.
When volatility rises, you can see that the indicator remains above the 50-handle. Sometimes, a peak above the 80-level is often seen as a strong indicator of volatility in the markets.
Over the years, traders have designed their own volatility based trading systems in use. One of the facts with the relative volatility index is that it can be applied to any markets and any time frame. As a result, this is one of the most widely used indicators when it comes to day trading the markets.
On the downside, the relative volatility index is not widely available in many trading or charting platforms. Therefore, traders will either need to build one or create a customized indicator that can measure volatility like the RVI does.
Trading with rising and falling volatility can give traders an extra edge in the markets. This is possible by using the relative volatility index which is a simple but an effective tool to ride the volatility within the trend.