The Random Walk Index was created by Michael Poulos who wanted to find an indicator that overcame the effects of a fixed look-back period as well as the drawbacks of traditional smoothing methods. The RWI is based upon the concept of the shortest distance between two points is a straight line. The further prices stray from that straight line within a given time, the less efficient the movement. The more random the movement, the greater the RWI fluctuates. To effectively use the RWI, Poulos recommends 2 to 7 periods for the short term and 8 to 64 periods for the long term. This is to illustrate the randomness of the short term and the trends of the long term. In the short term, peaks of RWI highs correlate with peaks in price. Peaks of RWI lows correlate with drops in price.
In the long term, peaks of RWI highs above 1.0 illustrate a strong uptrend. Peaks of RWI lows above 1.0 illustrate a strong downtrend.
A trading system using this index would be enter long (or close short) when the long-term RWI of highs is greater than 0 and short term RWI of lows rises above1.0. Likewise, when the long-term RWI of the lows is greater than 1.0 and the short-term RWI of highs rises above 1.0, enter short (or close long).