Stochastic RSI, or simply StochRSI, is a technical analysis indicator used to determine whether an asset is overbought or oversold, and to identify the current market trend. As the name suggests, StochRSI is a derivation of the standard Relative Strength Index (RSI), thus, it is considered an indicator of it. This is a type of oscillator, which means it fluctuates above or below the center line.
StochRSI was first introduced in 1994 in a book called The New Technical Trader, authored by Stanley Kroll and Tushar Chande. This is often used by stock exchange traders, but can also be applied to other trading contexts, such as the Forex and Digital Currency markets.
How does StochRSI work?
The StochRSI indicator is generated from ordinary RSI by applying the Stochastic Oscillator formula. The result obtained is an assessment number that is around the center line (0.5), with a range of 0-1. However, there is a modified version of the Stoch RSI indicator that multiplies the result by 100, so that the value ranges from 0 to 100 instead of 0 to 1. It is very common to see the 3-day simple moving average (SMA) along with the StochRSI line, which acts as a line signals and intends to reduce trading risks resulting from incorrect signals.
The standard Stochastic Oscillator formula uses the closing price of an asset along with the highest and lowest points in a period. However, when this formula is used to calculate StochRSI, it will be directly applied to RSI data (price is not considered).
Stoch RSI = (Current RSI - Lowest RSI)/(Highest RSI - Lowest RSI)Just like the standard RSI, the most commonly used timing for StochRSI is 14-period. The 14 periods involved in calculating StochRSI are based on timeframe charts. Where, the daily chart will use the last 14 days (candlesticks), the hourly chart will produce StochRSI based on the last 14 hours.
Periods can be set in days, hours, or minutes, and their usefulness varies greatly from one trader to another (depending on their profile and strategy). The number of periods can be adjusted up or down to identify longer or shorter trends. The 20-period setting is a fairly popular option for the StochRSI indicator.
As already mentioned, some StochRSI chart patterns determine values ranging from 0 to 100 and not 0 to 1, so, on these charts the center line is at point 50 and not 0.5. Therefore, the overbought signal which usually occurs at 0.8 will be at position 80, and the oversold signal will be at position 20 and not 0.2. Charts with a 0-100 setting may look slightly different, but the practical interpretation is the same.
How to use StochRSI?
The StochRSI indicator will be very important if it approaches the upper or lower limit of its range. Therefore, the main use of this indicator is to identify potential entry and exit points, as well as price turnover. So, a reading of 0.2 or below indicates that an asset may be oversold, whereas a reading of 0.8 or above indicates that the asset may be overbought.
Moreover, readings very close to the center line can provide important information about market trends. For example, when the center line acts as a support and the StochRSI line moves slowly above the 0.5 mark, this indicates a continuation of a bullish or upward trend - especially if the line starts to move towards 0.8. Likewise, readings consistently below 0.5 and moving towards 0.2 could indicate a bearish or downtrend.
StochRSI vs RSI
Both StochRSI and RSI are bracelet oscillation indicators that make it easier for traders to identify potential overbought and oversold conditions, as well as possible turnaround points. In short, standard RSI is a metric used to track how fast and how much an asset changes with correlation to a period of time.
However, when compared to the Stochastic RSI, the standard RSI indicator is slower and produces few trading signals. Application of the Stochastic Oscillator formula with standard RSI allows making StochRSI an indicator with higher sensitivity. Because of this, the number of signals generated is higher, giving traders more opportunities to identify market trends and potential buy and sell points.
In other words, StochRSI is a more fluctuating indicator, and this makes it a more sensitive TA tool that can help traders with improved trading signals, it is also riskier as it can sometimes give false trading signals. As already explained, applying a simple moving average (SMA) is a common method to reduce the risk associated with such erroneous signals, and in many cases, a 3-day SMA is included in the basic setup of the StochRSI indicator.
Conclusion
Due to its speed and greater sensitivity to market movements, Stochastic RSI can be an indicator for analysts, traders and investors - for short-term and long-term analysis. However, more signals mean more risk and, for this reason, StochRSI is recommended to be used in conjunction with technical analysis tools that can help confirm the signals it generates. It is also important to remember that digital currency markets fluctuate more than traditional markets and can give more false signals.