Stochastic RSI, or StochRSI for short, is a Technical Analysis (TA) indicator used to determine whether an asset is overbought or oversold and also to identify current market trends. As its name suggests, the StochRSI is a derivative of the standard Relative Strength Index and as such, is considered an indicator of an indicator. Functioning as a type of oscillator, it fluctuates above and below a central line.
StochRSI was first described in a 1994 book titled The New Technical Trader by authors Stanley Kroll and Tushar Chande. It is often used by stock exchange traders, but can be applied to other markets, such as Forex and cryptocurrencies.
How does StochRSI work?
The StochRSI indicator is generated from the common RSI by applying the Stochastic Oscillator formula. The result is a unique and numerical evaluation, which varies around a central line (0.5), within a range between 0 and 1. However, there are some modified versions of the StochRSI indicator that multiply the results by 100, so the values vary between 0 and 100, rather than 0 and 1. It is also common to see a 3-day Simple Moving Average (SMA) in conjunction with a StochRSI line, which acts as a signal line and aims to reduce trading risks based on false signals.
The standard Stochastic Oscillator formula considers the closing price of an asset in conjunction with its highest and lowest points over a certain period of time. However, when the formula is used to calculate StochRSI, it ends up being applied directly to the RSI data (prices are not considered).
Stoch RSI = (Current RSI - Lowest RSI)/(Highest RSI - Lowest RSI)Just like in the case of standard RSI, the most common time setting used for StochRSI is 14 periods. The 14 periods involved in calculating the StochRSI are based on the chart time. Therefore, while the daily chart would consider the last 14 days (candlesticks), an hourly chart would generate the StochRSI based on the last 14 hours.
These periods can be set to days, hours or even minutes and usage varies greatly from trader to trader (depending on profiles and strategies). The number of periods can also be adjusted up or down to identify long-term or short-term trends. A 20-period setting is another very popular option for the StochRSI indicator.
As previously mentioned, some StochRSI chart patterns assign values from 0 to 100, rather than 0 to 1. In these charts, the center line is at 50, rather than 0.5. Therefore, the overbought signal, which normally occurs at 0.8, is now triggered at 80 and the oversold signal at 20, instead of 0.2. The graphs with the 0-100 setting may look a little different, but the practical interpretation is essentially the same.
How to use StochRSI?
The StochRSI indicator assumes its greatest significance near the upper and lower limits of its range. Therefore, the primary use of the indicator is to identify potential entry and exit points, as well as price reversals. Thus, a reading of 0.2 or lower indicates that the asset is likely oversold, while a reading of 0.8 or higher suggests that the asset is overbought.
Furthermore, readings closer to the centerline can also provide useful information regarding market trends. For example, when the center line acts as support and the StochRSI lines move above the 0.5 mark, this may suggest the continuation of a bullish or bullish trend - especially if the lines begin to move towards the 0.8 mark. . Likewise, readings that are consistently below 0.5 and towards 0.2 indicate a bearish or bearish trend.
StochRSI vs. RSI
Both StochRSI and RSI are oscillation indicators that make it easier for traders to identify potential overbought or oversold conditions, as well as possible reversal points. In short, standard RSI is a metric used to track how quickly and to what extent an asset's prices change over a period of time.
However, when compared to Stochastic RSI, standard RSI is a relatively slow indicator that produces a small amount of signals for trading. The application of the Stochastic Oscillator formula to the regular RSI allowed the creation of the StochRSI, functioning as an indicator of greater sensitivity. Consequently, the number of signals it produces is much greater, giving traders more opportunities to identify market trends and potential buy or sell points.
In other words, StochRSI is a very volatile indicator. While this makes it a more sensitive technical analysis tool that can help traders with a greater number of signals, it is also riskier because it typically generates a fair amount of noise (false signals). As mentioned, applying Simple Moving Averages (SMA) is a common method to reduce the risks associated with false signals and, in several cases, a 3-day SMA is already included as a default setting of the StochRSI indicator.
Final considerations
Due to its greater speed and sensitivity to market movements, Stochastic RSI can be a very useful indicator for analysts, traders and investors - both for short-term 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 it creates. It is also important to keep in mind that the cryptocurrency market is more volatile than traditional ones, which can generate a large increase in the number of false signals.