The oscillator helps trader take advantage of both momentum indicators to make another indicator. The new indicator is more sensitive and synchronises well to the historical performance of a particular security. It doesn’t generalized analysis of price variation. In this article, we’ll go in-depth with the Stochastic RSI indicator.
- The Stochastic RSI indicator oscillates bchaetween 0 and 100.
- When it’s above 80, traders consider the market as overbought.
- When it’s below 20, traders consider the market as oversold.
- Overbought and oversold are a hint that price is overextended and is likely to be coming close to an extreme.
What is the Stochastic RSI indicator?
Stochastic RSI (StochRSI) is a technical analysis indicator used to determine if an asset is oversold or overbought. Some traders also use it to identify recent trends in the market. As the name suggests, the indicator comes from the regular Relative Strength Index (RSI). Due to this, you can see it as an indicator of an indicator. It is a kind of oscillator, which means that it fluctuates below and above a middle line.
Stanley Kroll and Tushar Chande were the first to describe the indicator in the 1994 book “The New Technical Trader”. The StochRSI is mostly used by stock traders, and in other trading contexts, like cryptocurrency and forex markets.
The indicator used in technical analysis that ranges from zero to one (or zero to 100 on some charts). It forms by applying the stochastic oscillator formula to some relative strength index (RSI) values rather than to standard price data. Traders get an idea whether the recent RSI is oversold or overbought when they use RSI values within the stochastic formula.
What does the StochRSI indicator tell traders?
Technical indicators were already used to indicate oversold and overbought levels. Despite this, the two StochRSI was created to improve sensitivity and create a better number of signals than traditional indicators could do.
The indicator is oversold when the value goes down below 0.20 according to the Stochastic RSI. This means that the RSI value is trading at the lower end of its predefined range. It also means that the short-term direction of the next security could be coming close to a low or possibly gets higher.
On the other hand, a reading greater than 0.80 means that the RSI may be getting to extreme highs. Traders may use it to indicate a pullback in the underlying security.
Together with identifying overbought/oversold situations, the indicator can be used to determine short-term trends. It can do this by looking at it in the context of an oscillator with a midpoint of 0.50. When the indicator is greater than 0.50, the security may be trending higher and vice versa (trending lower) when it’s lower than 0.50.
Traders should use the StochRSI together with other technical analysis chart patterns to maximize its effectiveness, particularly due to the high number of signals that it produces.
Also, non-momentum indicators such as the accumulation distribution line may be useful. They don’t overlap in terms of functionality and offer insights from a different point of view.
How to use the StochRSI?
The Stochastic RSI indicator uses the same oscillator principle to data derived from the RSI of an asset. It doesn’t use the price action. It is an indicator of an indicator that uses data from the RSI indicator. This indicator can help to identify when a market is overbought or oversold. StochRSI can be configured to use data from various trading times, just as it is with the traditional stochastic indicator.
For instance, if we have a period setting of 14, the values of RSI will be gotten from the last 14 trading points. Therefore, we can interpret data from the StochRSI of 14 periods as:
- A StochRSI reading of 100 shows the RSI level of the asset is at its maximum point in the last 14 points.
- A reading of 80 shows the RSI level of the asset is close to its high from the last 14 points.
- A StochRSI reading of 50 shows the RSI level of the asset is in a neutral point.
- A reading of 20 shows the RSI level of the asset is close its low from the last 14 points.
- A StochRSI reading of 0 means that the RSI level of the asset is at its least point in the past 14 periods.
- When the reading of a StochRSI of an asset drops lower than 20, it is seen as being oversold.
A level higher than 80 shows an overbought situation. Just as it is with the stochastic oscillator, StochRSI is also popularly accompanied by a 3-day moving average.
Biggest mistakes to avoid with the Stochastic RSI
The StochRSI indicator takes on its highest importance close to the lower and upper bounds of its range. Thus, the major use of the indicator is to determine reversals and potential entry and exit locations. So, a reading of 0.2 or below means that an asset is likely oversold. And a reading of 0.8 or above shows that it is probably overbought.
Also, readings that are nearer to the midpoint can also give important data regarding market trends. For example, the continuation of a bullish or upward trend happens when the centerline acts as a support and the StochRSI lines move steadily above the 0.5 point. This happens particularly if the lines begin to move toward 0.8. In the same way, a bearish trend happens when readings are consistently lower than 0.5 and trending toward 0.2.
The difference between the Stochastic RSI and the Relative Strength Index (RSI)
Both appear similar, but the StochRSI depends on another formula from what produces the RSI values. RSI calculates from price, while StochRSI is derivative of RSI, or a second derivative of price. One of the major variations is how fast the indicators move. StochRSI moves very fast from overbought to oversold, or vice versa, while the RSI is a much slower moving indicator. One isn’t better than the other, StochRSI just moves better than the RSI.
Pros & Cons
One disadvantage of using the StochRSI is that it can be quite volatile, moving quickly from low to high. Smoothing the StochRSI may help with this. There are traders who take a moving average of the StochRSI to lower the volatility and make the indicator useful. For instance, a 10-day simple moving average of the StochRSI can generate an indicator that is smoother and more stable.
Traders can apply one kind of oscillator to another without any personal calculations needed on many charting platforms.
Additionally, the StochRSI is the second derivative of price. This means that its output is two steps away from the real price of the asset which the trader analyses. It sometimes indicates that it may be out of sync with the market price of an asset in real time.
StochRSI vs. RSI – Which is better?
It is difficult to determine which is better because both indicators provide different data. The StochRSI is a measure of the strength of the regular RSI. The normal RSI is closer to the real price of the underlying trend because the first is an indicator of the latter.
The StochRSI can be a very important indicator for traders, analysts, and investors – for both long-term and short-term analysis. It is important because of its high speed and sensitivity to market movements. But more signals also indicate more risk. As a result of this, traders can use the StochRSI together with other technical analysis tools that may assist in confirming the signals it makes.
It is also necessary to remember that false signals can be seen because the cryptocurrency markets are more volatile than the traditional ones.