Stochastic RSI Explained
What is Stochastic RSI?
Stochastic RSI, or simply StochRSI, is a technical analysis indicator used to determine whether an asset is overbought or oversold, as well as to identify current market trends. As the name suggests, the StochRSI is a derivative of the standard Relative Strength Index (RSI) and, as such, is considered an indicator of an indicator. It is a type of oscillator, meaning that it fluctuates above and below a center line.
The StochRSI was first described in the 1994 book titled The New Technical Trader by Stanley Kroll and Tushar Chande. It is frequently used by stock traders, but may also be applied to other trading contexts, such as Forex and cryptocurrency markets.
How does StochRSI work?
The StochRSI indicator is generated from the ordinary RSI by applying the Stochastic Oscillator formula. The result is a single numerical rating that swings around a centerline (0.5), within a 0-1 range. However, there are modified versions of the StochRSI indicator that multiply the results by 100, so the values range between 0 and 100 instead of 0 and 1. It is also common to see a 3-day simple moving average (SMA) along with the StochRSI line, which acts as a signal line and is meant to reduce the risks of trading on false signals.
The standard Stochastic Oscillator formula considers an asset’s closing price along with its highest and lowest points within a set period. However, when the formula is used to calculate the StochRSI, it is directly applied to the RSI data (prices are not considered).
Stoch RSI = (Current RSI - Lowest RSI)/(Highest RSI - Lowest RSI)
Just like the standard RSI, the most common time setting used for the StochRSI is 14 periods. The 14 periods involved in the StochRSI calculation are based on the chart time frame. So, while a daily chart would consider the past 14 days (candlesticks), an hourly chart would generate the StochRSI based on the last 14 hours.
The periods could be set to days, hours or even minutes, and their use varies significantly from trader to trader (according to their profile and strategy). The number of periods can also be adjusted up or down to identify longer-term or shorter-term trends. A 20-period setting is another fairly popular option for the StochRSI indicator.
As mentioned, some StochRSI charting patterns assign values ranging from 0 to 100 instead of 0 to 1. On these charts, the centerline is at 50 instead of 0.5. Therefore, the overbought signal that usually occurs at 0.8 would be denoted at 80, and the oversold signal at 20 rather than 0.2. Charts with a 0-100 setting may look slightly different, but the practical interpretation is essentially the same.
How to use StochRSI?
The StochRSI indicator takes on its greatest significance near the upper and lower bounds of its range. Therefore, the primary use of the indicator is to identify potential entry and exit points, as well as price reversals. So, a reading of 0.2 or below indicates that an asset is probably oversold, while a reading of 0.8 or above suggests that it is likely to be overbought.
In addition, readings that are closer to the centerline can also provide useful information in regards to market trends. For instance, when the centerline acts as a support and the StochRSI lines move steadily above the 0.5 mark, it may suggest the continuation of a bullish or upward trend - especially if the lines start to move toward 0.8. Likewise, readings consistently below 0.5 and trending toward 0.2 indicate a downward or bearish trend.
StochRSI vs. RSI
Both StochRSI and RSI are banded oscillator indicators that make it easier for traders to identify potential overbought and oversold conditions, as well as possible reversal points. In short, the standard RSI is a metric used to track how quickly and to what degree the prices of an asset change in relation to a set time frame (period).
However, when compared to the Stochastic RSI, the standard RSI is a relatively slow-moving indicator that produces a small number of trading signals. The application of the Stochastic Oscillator formula to the regular RSI allowed the creation of the StochRSI as an indicator with increased sensitivity. Consequently, the number of signals it produces is much higher, giving traders more opportunities to identify market trends and potential buying or selling points.
In other words, the StochRSI is a fairly volatile indicator, and while this makes it a more sensitive TA tool that can help traders with an increased number of trading signals, it is also riskier because it often generates a fair amount of noise (false signals). As mentioned, applying simple moving averages (SMA) is one common method for reducing the risks associated with these false signals and, in many cases, a 3-day SMA is already included as a default setting for the StochRSI indicator.
Because of its greater speed and sensitivity to market movements, the Stochastic RSI can be a very useful indicator for analysts, traders, and investors - for both short-term and long-term analysis. However, more signals also mean more risk and, for this reason, the StochRSI should be used alongside other technical analysis tools that may help to confirm the signals it creates. It is also important to keep in mind that the cryptocurrency markets are more volatile than the traditional ones and, as such, may generate an increased number of false signals.