TRADING TECHNIQUES Refining The Relative
Volatility Index by Donald Dorsey
The relative volatility index was designed to measure the direction of volatilty. Since it was first introduced, however, its developer has not simply rested on his
laurels; here are further refinements on the original.
In 1993, when I introduced the relative volatility index (RVI), my intention was to demonstrate how greater
performance can be achieved if technical indicators are diversified in a trading system. My thinking was that since the vast majority of technical indicators are derived by calculating price change, a trading system could be improved if a confirming indicator, used as a filter, were added. This filter, the RVI, calculated strength by measuring volatility rather than price change, adding the diversification previously lacking in many systems.
Since then, I've repeatedly been asked how the RVI could be used to measure long-term market trends, the most common usage of filters by traders. In truth, there are several advantages to using a long-term filter in a trading system; not only does it tend to reduce the number of trades and thereby your expenses, it can also provide quantifiable evidence to determine the trend and add diversity by measuring trend strength over a different time span.
WHAT A TREND IS
Before designing a trend indicator, one must first determine what a trend is. One theory holds that a trend is simply the outward result of inertia. Once a market begins to move, it takes significantly more energy for it to change direction than for it to continue along the same path. Therefore, a measurement of trend is really a measurement of market inertia.
Looking at inertia requires two inputs, direction of motion and mass. Direction is easy, even though some may argue that determining the time frame over which to define a direction is difficult. Once decided, however, the direction of the market relative to that time frame is self-evident. For example, defining a trend as whether the market is above or below its 200-day moving average is a simple calculation based entirely on market direction.