Stochastic RSI (StochRSI) is a powerful technical analysis tool that combines the sensitivity of the Relative Strength Index (RSI) and the rapid signal detection capability of the Stochastic Oscillator.
Introduced by Stanley Kroll and Tushar Chande, StochRSI has become a popular indicator not only in stock trading but also in markets like Forex and cryptocurrencies.
The following article will explain in detail how it works, practical applications, and the differences between StochRSI and RSI, providing you with insights into a tool that effectively identifies overbought, oversold states and market trends.
What is Stochastic RSI?
Stochastic RSI, commonly referred to as StochRSI, is a technical analysis indicator used to determine the overbought or oversold state of an asset, as well as the current market trend.
True to its name, StochRSI is a variant of the standard Relative Strength Index (RSI), hence considered an 'indicator of an indicator'.
This is a type of oscillator, meaning it oscillates up and down around a central line.
StochRSI was first introduced in the book The New Technical Trader in 1994 by Stanley Kroll and Tushar Chande.
This indicator is often used by stock traders but can also be applied in other trading contexts, such as the Forex market and cryptocurrencies.
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How does StochRSI work?
StochRSI is derived from the standard RSI by applying the Stochastic Oscillator formula. The result is an index oscillating around the midpoint (0.5), ranging from 0 to 1.
However, there are modified versions of StochRSI that multiply the result by 100, causing the values to oscillate between 0 and 100 instead of 0 and 1.
Additionally, there is often an accompanying 3-day simple moving average (SMA) along with the StochRSI, which helps reduce the risk from false signals.
The standard Stochastic Oscillator formula considers the closing price of the asset along with the highest and lowest levels over a specific period.
However, when applied to StochRSI, this formula is calculated directly based on RSI data (not considering the asset price):
Similar to RSI, the most commonly used period for StochRSI is 14 periods. These periods can be adjusted according to the chart's time frame.
For example, a daily chart will consider the past 14 days (daily candles), while an hourly chart will calculate based on the previous 14 hours.
The number of periods can be adjusted for long-term or short-term trend analysis. Another popular setting is 20 periods.
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In charts using a range from 0 to 100 instead of 0 to 1, the midpoint is at 50 instead of 0.5. Therefore, overbought signals often appear at 80 (instead of 0.8), and oversold signals appear at 20 (instead of 0.2). Despite the difference in appearance, the interpretation remains unchanged.
How to use StochRSI
StochRSI is most significant when its value approaches the upper and lower boundaries of the range. Therefore, the primary application of this indicator is to identify potential entry and exit points, as well as price reversals.
Oversold: An index level of 0.2 or lower indicates that the asset is likely being oversold.
Overbought: An index level of 0.8 or higher indicates that the asset is likely being overbought.
Additionally, values near the midpoint also provide useful information about market trends. For instance, if the midpoint (0.5 or 50) acts as support and StochRSI consistently moves above this level, it may indicate that an uptrend is still ongoing, especially if the indicator approaches 0.8 (or 80).
Conversely, values below 0.5 (or 50) trending towards 0.2 (or 20) indicate that a downtrend is prevailing.
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Comparing StochRSI and RSI
Both StochRSI and RSI are oscillators that help traders identify overbought, oversold states, and potential reversal points. However, the standard RSI is a slower indicator that generates fewer trading signals.
Conversely, applying the Stochastic Oscillator formula to RSI results in StochRSI with higher sensitivity, providing more signals.
This makes StochRSI a useful tool for detecting trends and potential buy/sell points. However, high sensitivity also comes with risks, as StochRSI can easily generate false signals.
A common method to mitigate this risk is to use the simple moving average (SMA), which is typically preset with a default period of 3 days.
Conclusion
Thanks to its speed and high sensitivity to market fluctuations, Stochastic RSI is a useful analysis tool for both short-term and long-term traders. However, the increased number of signals also equates to higher risk.
Therefore, StochRSI should be used in conjunction with other technical analysis tools to confirm signals. It is important to note that the cryptocurrency market is often more volatile than traditional markets, increasing the risk of noise signals.