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 determine current market trends. As the name suggests, the StochRSI is a derivative of the standard Relative Strength Index (RSI) and as such is considered a stock indicator. It is an oscillator type, meaning that it fluctuates above and below the center line.
StochRSI was first described in the 1994 book The New Technical Trader by Stanley Kroll and Tushar Chande and is frequently used by stock traders but may also be applied to other trading contexts such as the Forex and cryptocurrency markets.
How does StochRSI work?
The StochRSI indicator is generated from the normal RSI by applying the Stochastic Oscillator formula and the result is a single numerical rating that oscillates around the center line (0.5) within a range of 0-1. But 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 three-day simple moving average (SMA) with a StochRSI line which acts as a signal line and is intended to reduce trading risk ( such as false signals).
The Stochastic Oscillator formula takes into account the closing price of an asset along with the highest and lowest points over a specific period. However, when the formula is used to calculate StochRSI, it is applied directly to the RSI data (prices are not considered).
Stoch RSI = (Current RSI - Lowest RSI)/(Highest RSI - Lowest RSI)It works just like the RSI, the most common time setting used in StochRSI is 14 periods. The 14 periods included in the StochRSI calculation are based on the time frame of the chart. So, while the daily chart looks at the past 14 days (candlesticks). The hourly chart generates the StochRSI indicator based on the last 14 hours.
Periods can be set to days, hours or even minutes and their use varies greatly from one trader to another (according to their profile and strategy). The number of periods can also be adjusted up or down to identify long-term or short-term trends. The 20 period setting is a fairly popular option for the StochRSI indicator.
As mentioned before, some StochRSI chart patterns assign values ranging from 0 to 100 instead of 0 to 1. In these charts the middle line is at 50 instead of 0.5. Therefore, an overbought signal that usually occurs at 0.8 will be indicated at 80 and an oversold signal at 20 instead of 0.2.
Charts with a setting of 0-100 may look a little different but the practical interpretation is consistent.
How to use StochRSI?
The StochRSI takes its greatest significance near the upper and lower limits of its range. Therefore, the main use of the indicator is to identify potential entry and exit points as well as price reversals. Therefore, a reading of 0.2 or lower indicates that an asset may be oversold while a reading of 0.8 or higher indicates that it is likely overbought.
In addition, readings near the center line can also provide useful information regarding market trends. For example, when the middle line acts as support and the StochRSI lines move steadily above the 0.5 area, this may indicate a continuation of the uptrend, especially if the lines start moving towards 0.8. Likewise, readings consistently below 0.5 and trending toward 0.2 indicate a bearish or bearish trend.
StochRSI vs. RSI
Both StochRSI and RSI (Regular Relative Strength Index) are range oscillator indicators that make it easier for traders to identify overbought and oversold conditions as well as potential reversal points. In short, the Relative Strength Index (RSI) is used to track how quickly and how quickly an asset's prices change with respect to a specified time frame (period).
But when we compare the RSI to the Stochastic RSI, we will notice that the standard RSI is a relatively slow-moving indicator that produces a small number of trading signals. Applying the Stochastic Oscillator formula to the usual RSI allowed the StochRSI to be created as an indicator with increased sensitivity. Therefore the number of signals it produces is much higher which gives traders more opportunities to identify market trends and potential buy or sell points.
In other words, the StochRSI is a rather volatile indicator and while this makes it a more sensitive technical analysis (TA) tool that can help traders by increasing the number of trading signals, it is also more dangerous because it often generates a fair amount of volatility. Noise (false signals). As mentioned earlier applying simple moving averages (SMA) is one of the popular techniques to reduce the risks associated with these false signals and in many cases 3-day SMAs are actually used as the default setting for the StochRSI indicator.
Concluding thoughts
The Stochastic RSI can be a very useful indicator for analysts, traders and investors due to its speed and increased sensitivity to market movements for both short-term and long-term analyses. However, more signals also mean greater risk which is why StochRSI should be used alongside other technical analysis tools that may help confirm the signals it creates.
It is also important to note that cryptocurrency markets are more volatile than traditional markets and as such may generate an increased number of false signals.