Introduction to Relative Volatility
Volatility is a fundamental aspect of financial markets, reflecting the rate at which prices fluctuate over a given period. However, relative volatility, in particular, is an important concept that traders use to gauge the market’s stability or turbulence relative to its historical performance or a benchmark.
Relative volatility compares the volatility of an asset to another asset, a benchmark index, or its past volatility to determine potential trading opportunities. Unlike absolute volatility, which measures raw price movements, relative volatility provides a comparative framework that traders can use to make informed decisions about risk and market conditions.
Understanding Relative Volatility Index (RVI)
The Relative Volatility Index (RVI) is a technical indicator developed by Donald Dorsey that measures the standard deviation of price changes over a given period. The RVI is similar to the Relative Strength Index (RSI), but instead of tracking price momentum, it focuses on price volatility.
Calculation of RVI
- Compute the standard deviation of the price changes over a selected period (typically 10 or 14 days).
- Apply a smoothing mechanism such as a simple or exponential moving average.
- Normalize the results to create an oscillator that ranges between 0 and 100.
A high RVI value indicates increased volatility, whereas a low value suggests a calmer market. Traders use this information to determine entry and exit points, as high volatility often precedes strong price movements.
Trading Strategies Using Relative Volatility
1. Relative Volatility and Trend Confirmation Strategy
Concept
Relative volatility can be used to confirm trends by assessing whether an increase in volatility supports an existing trend. This strategy involves:
- Using moving averages (e.g., 50-day and 200-day) to identify trends.
- Observing the RVI to confirm the trend’s strength.
Example
- If the price is above the 50-day and 200-day moving averages and the RVI is rising, it confirms the strength of the uptrend, signaling a good entry for long trades.
- If the price is below the moving averages and the RVI is increasing, it confirms a strong downtrend, signaling short trade opportunities.
2. Relative Volatility Breakout Strategy
Concept
Markets often experience periods of low volatility followed by high volatility, leading to strong price breakouts. The relative volatility strategy aims to capitalize on these breakouts.
How to Trade
- Identify assets with historically low RVI values, indicating reduced volatility.
- Wait for a sudden spike in RVI alongside a price breakout above or below key resistance/support levels.
- Enter long positions when the price breaks resistance with rising RVI.
- Enter short positions when the price breaks support with increasing RVI.
Example
A stock trading in a narrow range for several weeks with a declining RVI suddenly sees a sharp increase in RVI along with a breakout above a resistance level. This signals a strong bullish move, making it a favorable long trade setup.
3. Mean Reversion with Relative Volatility
Concept
Markets often revert to their mean after extreme price movements. When volatility spikes abnormally, prices tend to correct back to the mean, creating trading opportunities.
How to Trade
- Identify assets with extreme RVI readings (e.g., above 80 or below 20).
- Look for divergence between price and RVI.
- Enter counter-trend trades when the price shows signs of reversal.
Example
If a stock has an RVI above 80 and is trading significantly above its 20-day moving average, it may indicate an overbought condition. If the price shows signs of reversing, traders can enter short positions, expecting a return to the mean.
4. Relative Volatility with Bollinger Bands
Concept
Bollinger Bands measure price volatility using standard deviations. Combining RVI with Bollinger Bands helps confirm breakouts and trend continuations.
How to Trade
- Identify price touching or exceeding the upper or lower Bollinger Band.
- Check if RVI is increasing, confirming a breakout’s strength.
- Enter long trades when the price breaks the upper band with increasing RVI.
- Enter short trades when the price breaks the lower band with rising RVI.
Example
If a currency pair is trading near its upper Bollinger Band and the RVI is increasing, it signals strong momentum and a potential breakout, providing a long entry opportunity.
5. Relative Volatility and RSI Divergence
Concept
Combining RVI with RSI (Relative Strength Index) allows traders to detect potential reversals.
How to Trade
- Identify divergence between RSI and price action.
- Confirm with RVI to assess volatility levels.
- Enter trades when RSI signals overbought/oversold conditions while RVI remains low or shows divergence.
Example
If a stock makes a higher high, but RSI shows a lower high while RVI is declining, it signals a potential reversal. Traders can enter short positions.
Risk Management and Best Practices
- Use Stop-Loss Orders: Volatility can lead to sharp price movements, making stop-loss orders essential to protect capital.
- Adjust Position Sizing: Trade smaller sizes when volatility is high to reduce risk.
- Combine with Other Indicators: RVI alone may not be sufficient. Use it with trend-following and momentum indicators for better accuracy.
- Avoid Overtrading: High volatility can lead to emotional trading. Stick to well-defined strategies.
- Backtesting and Paper Trading: Before implementing real trades, backtest strategies using historical data to evaluate performance.
Conclusion
Relative volatility is a powerful tool for traders, offering insights into market conditions, breakout opportunities, and trend confirmation. By utilizing strategies like trend confirmation, breakout trading, mean reversion, and Bollinger Band combinations, traders can make informed decisions and improve their market edge. However, proper risk management is crucial to navigating volatile conditions effectively. With thorough analysis and disciplined execution, relative volatility can be a valuable addition to any trader’s toolkit.