In a recent blog post, one of our readers commented that they found the RVI to be a useful indicator. That comment illustrates what we try to accomplish with our blogs. We strive to introduce our readers to new ideas that they can use to improve their results. By explaining RVI we saw an opportunity to advance our goal.
This is an indicator most traders haven’t heard of. The Relative Vigor Index, or RVI, was developed by John Ehlers and was first published in the January 2002 of Technical Analysis of Stocks and Commodities magazine. Ehlers has been a frequent contributor to that publication over the years and his work is largely focused on decreasing the lag time of technical indicators.
Lag time is shown in the chart below which includes a moving average. Arrows are used to show the lag between the change in the price trend and the turn in the moving average.
All indicators suffer from this problem and give signals after prices reverse. A number of indicators attempt to solve this problem by generating signals that occur closer to the trend reversal. RVI is one of the indicators developed to address the problem of lag times.
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RVI is based on the idea that prices tend to close above the open during up trends while closes tend to be below the open during down trends. Ehlers believed the vigor (or strength) of the trend could be understood by using that relationship. The formula for the basis of the indicator is:
(Close – Open) / (High – Low)
The numerator (close – open) measures the vigor of the trend. The denominator (high – low) normalizes the indicator so that values are directly comparable no matter what the price of the stock is. Without the denominator, a high-priced stock would always show more strength than a low-price stock even though a $10 move in a $100 stock (a 10% move) is weaker than a $1 move in a $2 stock (a 50% move).
RVI is a variation of an idea expressed by trading legend Larry Williams in the 1970s. Williams’ accumulation/distribution (A/D) oscillator was the first to be based on the concept that prices typically end the day higher in up trends and lower in down trends.
Ehlers liked the idea but believed the problem with the A/D oscillator was that it didn’t give consistent trading signals. The raw calculation is shown as the red line in the chart below.
The red line is jagged, with frequent crosses above and below the zero line. Because of the way the indicator is calculated, it will always be between -1 and +1. Signals are generated when the indicator crosses the zero line. Some software will change the range, for example to 0 to 100 which makes trade signals occur on crossovers of the 50 line.
To solve the problem of frequent buy and sell signals, Ehlers added a moving average to the calculation. The indicator can then be shown as two lines or with one line by calculating a ratio of the moving averages in the formula. RVI, as a ratio, is shown as the green line at the bottom of the chart above. You can see there are now only a few signals and the indicator is tradable.
RVI is smoothed with a 4-day moving average (MA) in the calculation. The formula can be written as
[4-day MA of (Close – Open)] / [4-day MA of (High – Low)]
We’ve used a triangular MA in the chart above. A triangular MA over weights the data in the middle of the calculation. In a simple MA each data point carries equal weight. By over weighting the data in the middle, the MA is smoother and should more closely track the cyclical elements of the data series.
By taking a ratio of the MAs, the indicator will still always have a value between -1 and +1 and signals are still generated when the indicator crosses above or below the zero line.
RVI could be appealing to some traders simply because so few traders know about it. They might believe there is value in using indicators that are more obscure. We want to put that idea to the test.
In the next chart, we have added a traditional MACD indicator along with RVI at the bottom of the chart. This chart illustrates one of the reasons we chose to detail the RVI.
Visually, MACD is similar to RVI. Sometimes the signals in MACD are earlier than the signals from RVI and at other times RVI signals earlier. Both indicators identify winning sometimes and losing trades on occasion. Presented on the same chart like this, it’s often obvious many indicators provide similar results.
While they look similar, MACD and RVI provide different results.
Using the more familiar MACD indicator, we tested buy signals for the SPDR S&P 500 ETF (NYSE: SPY) over the past ten years. Taking all trades and selling when the MACD histogram crossed below the zero-line, you would have enjoyed winners 65.5% of the time and achieved a total return of 81% on your investment.
We used the same testing process for RVI. With this less well-known indicator, the win rate was only 54.9% and the total return was significantly less at just 37%.
A buy and hold investor would have enjoyed a total return of more than 125% over those same ten years but would have suffered a steep loss during the bear market that began in 2008. Either indicator, the MACD or RVI, would have moved to cash during the bear market and reduced the worst drawdown by a significant amount.
Reduced risk is one of the important uses of indicators. It’s possible a bear market could have life changing consequences. If you had planned to retire in the middle of 2009, for example, the bear market could have resulted in losses so steep that you might have been forced to work another few years. Using a technical indicator and following the sell signals could have kept your retirement on track.
The ability to reduce risk with indicators is one of the points we wanted to highlight in this post. The other points are:
- Most technical indicators can be used to generate profits but the level of the profit may be disappointing to some investors.
- Many traders believe less well-known indicators can be more useful than popular tools. This can be true but is not always true. As testing showed, RVI does not beat MACD as a standalone trading tool.
- To beat the market in the long run, a combination of indicators should be considered.
That brings us to the question of which indicator you should use in your trading. The truth is almost any indicator can be applied profitably as long as you follow a sound process with discipline. Some indicators will be more profitable than others and this has led many traders to look at different indicators. You should use the indicator you are most comfortable with.
Beating the market is possible but isn’t easy. We often write about strategies that include fundamental indicators or combine technical and fundamental indicators. This is a useful strategy and many investors may find this helps them to increase their profits. This is because technical indicators tend to reinforce each other rather than add new information to the decision process. As the chart above shows, MACD and RVI provide similar signals even though they are calculated differently. This is true of many technical indicators which simply provide redundant rather than new information.
We’ll continue highlighting more obscure indicators alongside tools you might be familiar with as we strive to help you find strategies that work. We believe with information, you can find success.