The 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 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 can 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 score that oscillates around a center line (0.5), within a range of 0-1. 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 intended to reduce the risks of trading with false signals.
The standard Stochastic Oscillator formula considers the closing price of an asset along with its highest and lowest points within a given period. However, when the formula is used to calculate the StochRSI, it is applied directly to the RSI data (prices are not considered).
Stoch RSI = (Current RSI - Lowest RSI)/(Highest RSI - Lowest RSI)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 last 14 days (candlesticks), an hourly chart would output the StochRSI based on the last 14 hours.
Periods can be set in days, hours or even minutes, and their usage varies significantly from one trader to another (depending on their profile and strategy). The number of periods can also be adjusted up or down to identify longer-term or short-term trends. A 20 period setup is another fairly popular option for the StochRSI indicator.
As mentioned, some StochRSI chart patterns assign values ranging from 0 to 100 instead of 0 to 1. On these charts, the center line is at 50 instead of 0.5. Therefore, the overbought signal that usually occurs at 0.8 will be denoted as 80, and the oversold signal at 20 instead of 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 becomes most important near the upper and lower limits of its range. Therefore, the main use of the indicator is to identify possible entry and exit points as well as price reversals. Therefore, a reading of 0.2 or lower indicates that an asset is likely oversold, while a reading of 0.8 or higher suggests it is likely overbought.
Additionally, readings that are closer to the centerline can also provide useful information regarding market trends. For example, when the center line acts as a support and the StochRSI lines are consistently moving above the 0.5 mark, it may suggest the continuation of an uptrend, especially if the lines begin to move towards 0.8. Likewise, readings consistently below 0.5 and trending towards 0.2 indicate a bearish trend.
StochRSI vs RSI
Both StochRSI and RSI are band oscillator indicators that make it easier for traders to identify potential overbought and oversold conditions, as well as potential reversal points. In short, the standard RSI is a metric used to track how quickly and degree to which an asset's prices are changing relative to a given time period (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 greater sensitivity. Consequently, the number of signals it produces is much larger, giving traders more opportunities to identify market trends and potential buy or sell points.
In other words, the StochRSI is a fairly volatile indicator, and although this makes it a more sensitive AT tool that can help traders with a greater number of trading signals, it is also riskier because it often generates a good amount noise (false signals). As mentioned, applying simple moving averages (SMA) is a common method to reduce 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.
In conclusion
Due to its greater speed and sensitivity to market movements, the stochastic RSI can be a very useful indicator for analysts, traders and investors, both for short and long-term analysis. However, more signals also mean more risk and for this reason, StochRSI should be used in conjunction with other technical analysis tools that can help confirm the signals you create. It is also important to note that cryptocurrency markets are more volatile than traditional ones and, as such, can generate a greater number of false signals.