The Indicator Series: Candle Strengths, Understanding the Relative Vigor Index

Through the indicator series of posts we have discussed many different indicators used in trading and how they could be implemented in algorithmic trading strategies. We have talked about the mathematical calculations behind these indicators and what some of their possible interpretations might be. One of the indicators we discussed – the stochastic oscillator – tells us where price is relative to the high/low range of a given number of periods and is therefore a good indicator to help us see breakout and enable us to see where price is within a specific price range. Today we’re going to study a close cousin of this indicator, the relative vigor index, which makes use of a similar idea to help us interpret what the market is doing. This indicator can also be thought of as a volatility adjusted momentum indicator, perhaps the simplest one in this regard (compared for example with the ultimate oscillator described within the last article of the series).

The Relative Vigor Index (RVI) is a very simple indicator whose objective is simply to show us the “vigor” of a bullish or bearish movement. The indicator is calculated through a very simple equation in which the vigor index of each bar is simply determined by (Close-Open)/(High-Low) of that same bar and the RVI is simply the average of the relative vigor index during a certain number of periods. Note that the RVI is naturally normalized to a range between -1 and 1 but you can get more intuitive values of the indicator if you multiply its result by 100 to normalize it between -100 and 100. Note that the indicator calculates how much a movement represents relative to the total movement within a given bar so it gives us a volatility adjusted measurement of directionality.

The RVI differs significantly from the stochastic oscillator in the sense that it doesn’t calculate simply the place where we are relative to a range but how meaningful movements have been on candles relative to each candle’s high/low value within the past X periods. If there is a move towards the upside with strong momentum (candles with small wicks and large bodies) the RVI will start to increase as these candles will have a large body to range ratio and therefore will represent increases in the value of the indicator. On the contrary if we go into a consolidation period the RVI will inevitably start to drop as candles will have mixed directions and will also have low body to range ratios. The RVI is therefore a very useful momentum indicator since it clearly shows how meaningful movements have been.

Usually the RVI is also plotted with a 4 period moving average of its values which many traders use as signals for trading. The logic behind this is that when the RVI falls below the consensus of its value within the past 4 periods there is a marked tendency of candle to have continuosly larger bodies relative to their range and therefore there is most likely a continuation of momentum to take place. However this straight interpretations would lead to overall losses as the MA cross signal of the RVI doesn’t have a positive mathematical expectancy on at least the most commonly traded Forex major pairs.

Trading with the RVI successfully potentially requires a much more in-depth interpretation of what the indicator is telling us. The RVI gives us a volatility adjusted measurement of momentum in which we can know the average vigor of candle movements in one direction during the past X periods therefore declining or ascending values from RVI extremes suggest that a consolidation movement is developing (values dropping from a previously developing trend) and therefore after a certain period of decline a breakout trade is setup which can lead to successful trend capturing. Note that dropping values on the RVI can mean that there are more candles with low body to range ratios or an almost even number of large bearish and bullish candles within the past X periods. Either way both of these scenarios represent indecision leading to breakout opportunities. Using a shorter period RVI (like a 10 period) may be a good place to start for the developing of an algorithmic trading strategy using this technique on the daily charts.

The RVI is a useful indicator for the determination of consolidation in order to help us automate the detection of regions which might be useful for the creation of breakout thresholds since it allows us to know if from a volatility adjusted perspective the current scenario we’re looking at is actually the entry into consolidation. This is the main role we would expect a short term RVI to carry out as it can change very fast towards values near zero when momentum starts to drop and a consolidation phase forms. Longer period RVI values can be useful for the determination of reversals and the capturing of opposite trends. For example when the same scenario as the above (extreme value and then return to lower values) happens on a 30-50 period RVI we’re looking most probably at a full rebound in momentum which means that a trade towards the opposite side might be triggered.

How versatile the RVI is will depend on how powerful your interpretation of its meaning is. The important thing here is to remember that the RVI is telling you about the average of volatility adjusted movements within candles and therefore it is telling you how things “add up”. In a short term RVI a return to zero from an extreme most likely implies the establishment of a consolidation while in a longer period RVI (since you get a net zero from a higher number of periods) it usually implies that a movement in one direction has been equalized by a movement in the opposite direction (a reversal). Certainly – as with all indicators – it is not a matter of simply following lines but a matter of understanding the math behind them and creating signals based on sound market interpretations of their meaning. Remember that the above mentioned ways of usage are suggestions and adequate statistical evaluation of them within a full system is needed to ascertain their potential for the building of long term profitable algorithmic strategies.

If you would like to learn more about my work in automated trading and how you too can learn to use indicators in a sound manner please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)

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