Stocks & Commodities V.

11:6 (253-256): The Relative Volatility Index by Donald Dorsey

The Relative Volatility Index

by Donald Dorsey

STOCKS & COMMODITIES contributor Donald Dorsey takes the basic relative strength index and modifies it
to measure volatility instead of daily net price change to generate trading signals.

T echnicians are often tempted to use one set of indicators to confirm another. We may decide to use
the moving average convergence/divergence (Macd) to confirm a signal in stochastics or use momentum
readings to confirm moving average models. Logic tells us that this form of diversification of indicators
will enhance results, but too often the confirming indicator is just the original trading indicator
repackaged, each using a theory similar to the other to measure market behavior. It is not unlike taking
two wind direction readings rather than reading the wind direction and barometric pressure to predict
tomorrow's weather. Thus, the enhancement we sought through diversification results in loss, and we are
left wondering why our indicators don't seem to perform much better. Every trader should understand the
indicators being applied to the markets to avoid duplicating information.

RESEARCH AND COMBINATION

I have been researching the combination of two indicators, the first a timing indicator and the second
confirming the first. The first indicator is a dual moving average crossover and is confirmed by a measure
of directional volatility. I call the directional volatility measure the relative volatility index (RVI).
The RVI (see sidebar, "Relative volatility index") is simply the relative strength index (R SI) with the
standard deviation over the past 10 days used in place of daily price change. Because most indicators use
price change for their calculations, we need a confirming indicator that uses a different measurement to
interpret market strength. The RVI measures the direction of volatility on a scale of zero to 100. Readings

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Stocks & Commodities V. 11:6 (253-256): The Relative Volatility Index by Donald Dorsey

above 50 indicate that the volatility as measured by the 10-day standard deviation of the closing prices is
more to the upside. Readings below 50 indicate that the direction of volatility is to the downside. The
initial testing indicates that the RVI can be used wherever you might use the RSI and in the same way, but
the specific purpose of this study is to measure the RVI's performance as a confirming indicator.
As a test we selected a 10-bar simple moving average crossing a 20-bar simple moving average as our
trading indicator. Six markets were tested, with each test covering 650 bars. The bar length was one hour.
As a confirming indicator we will use the RVI with the six trading rules as follows:
1 Only take buy signals from moving average crossover when RVI > 50.
2 Only take sell signals when RVI < 50.
3 Enter the market long if after an ignored buy signal the RVI rises to 60 or above.
4 Enter the market short if after an ignored sell signal the RVI falls to 40 or below.
5 Exit a long position if the RVI falls to 40 or below.
6 Exit a short position if the RVI rises to 60 or above.

Technicians are tempted to use one set of indicators to confirm

another.... But too often the confirming indicator is just the
original trading indicator repackaged, each using a theory similar
to measure behavior.
An ignored buy signal by the moving average crossover will occur if the moving averages crossed but the
RVI was below 50. An ignored sell signal by the moving average crossover will occur if the moving
averages crossed but the RVI was above 50. Keep in mind we are not necessarily looking for a profitable
trading system; instead, we want to determine if the RVI can enhance the performance of our indicator by
diversifying our trading methodology.

RESULTS , WITH AND WITHOUT RVI

Figure 1 outlines the results of six tests performed with and without the RVI. We also calculated results
using the RSI as a confirming indicator with the same set of trading rules. This way, we could tell if our
attempt at diversification was having the desired effect, or if another confirming indicator reducing the
number of trades would have worked equally well.
In studying the results the most striking figure is a $8,175 profit with the RVI versus a $ 12,762.50 loss
without it — a total difference of almost $21,000! Equally impressive, however, is the improved
profitability in five of the six markets tested, showing us that the RVI improved a wide breadth of trades
and is unlikely to owe its superior performance to several big gainers. The RVI enhanced the profit to loss
ratio in five of the six markets and improved the win percentage in four of the six with the total results of
each again solidly in favor of the RVI sample.
So the early returns on the RVI appeared to show some promise, but how did they compare to our RSI test
sample? Using the RSI as a filter did seem to enhance results over the unfiltered test. We only suffered a

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 10, 20 MOVING AVERAGE CROSSOVER RESULTS
No confirming indicator
Market Record %Win Avg Pft/ Profit
Avg Loss
Lumber 10-19 34.5% 1.41 ($2,955.00)
S&P 500 10-18-1 35.7 1.59 ($2,275.00)
Dmark 9-21 30.0 1.88 ($3,525.00)
Soybeans 10-15 40.0 1.35 ($637.50)
Live cattle 11-21 34.4 0.90 ($3,040.00)
Gold 11-24-1 31.4 2.01 ($330.00)
Total 61-118-2 34.1% 1.56 ($12,762.50)

RSI as confirming indicator

Market Record %Win Avg Pft/ Profit
Avg Loss
Lumber 8-15 34.8% 1.26 ($3,780.00)
S&P 500 9-13 40.9 1.26 ($1,975.00)
Dmark 7-14 33.3 2.52 $2,962.50
Soybeans 8-14 36.4 1.60 ($525.00)
Live cattle 7-17 29.2 1.07 ($2,110.00)
Gold 6-19-1 24.0 2.70 ($600.00)
Total 45-92-1 32.8% 1.81 ($6,027.50)

RVI as confirming indicator

Market Record %Win Avg Pft/ Profit
Avg Loss
Lumber 8-12 40.0% 1.60 $540.00
S&P 500 9-10-1 47.4 2.06 $5,200.00
Dmark 7-12 36.8 2.46 $4,050.00
Soybeans 6-11 35.3 1.43 ($825.00)
Live cattle 5-19-1 20.8 1.86 ($2,160.00)
Gold 10-12 45.5 1.96 $1,370.00
Total 45-76-2 37.2% 2.10 $8,175.00
* Results are calculated based on one contract and make no correction
for commission costs.

FIGURE 1: The first section are results of just the crossover trades. The record column is the number of winning trades
and the number of losing trades. The second section employs the relative strength index as a confirming tool. The final
section uses the relative volatility index as a confirming tool. Note the total profits increase with the use of a confirming
indicator.

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Stocks & Commodities V. 11:6 (253-256): The Relative Volatility Index by Donald Dorsey

$6,027.50 loss with the RSI versus a $12,762.50 loss with the moving averages alone. Upon closer
inspection, however, if we were to exclude the Deutschemark results, the sample using the R SI only
performed $247.50 better, not the type of breadth that lends confidence to results. In addition, although
the profit to loss ratio definitely seemed to be helped by the RSI filter, the percentage of winning trades
was actually hurt. So although the RSI filter did seem to improve results somewhat, the performance of
the RVI filter was clearly superior both in raw figures and breadth of performance.
From these initial results, it would seem that our indicator indeed benefits from the diversification that
the RVI brought to our trading signals. To be thorough, we should test and document a variety of
indicators with the RVI, but personal experience with the RVI suggests that expected results should be
similar.
The other issue that should be addressed is the selection of the trading rules. For our test, we chose what
we thought were common sense rules. Because readings above 50 indicate a strong market and those
below 50 a weak one, we used that level as our guide on whether to go long or short. A common use of
the RSI, though, is as an overbought/oversold indicator, selling 70 and above and buying 30 and below.
As stated earlier, the R VI can be used wherever you currently use the RSI and in the same manner. But
remember, there is no reason to expect the R VI to perform any better or any worse than the RSI as an
indicator in its own right. The RVI's advantage is as a confirming indicator because it provides a level of
diversification missing in the RSI.

WORKING IN UNISON
Using a diverse set of indicators to measure the market is an old idea, but it is still something that many
traders overlook. The RVI appears to meet our requirements without eliminating too many trades or
requiring years of study to master. There are a few well-known studies measuring volume and open
interest that investors may wish to examine, but a set of good confirming indicators is in short supply.
We are quickly reaching the era in technical analysis where the emphasis will not be on the performance
of a single indicator, but on a basket of indicators developed specifically to work together.
Donald G. Dorsey is president of Galahad Systems, an investment software company specializing in
maximizing the performance of technical indicators.

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