What Is Stochastic RSI?
The StochRSI indicator is a widely used tool in technical analysis that helps traders determine if an asset is overbought or oversold and identify market trends. As an oscillator, it fluctuates above and below a center line and is a derivative of the Relative Strength Index (RSI), hence considered an indicator of an indicator.
Stanley Kroll and Tushar Chande introduced StochRSI in their 1994 book, The New Technical Trader. Although stock traders frequently use it, StochRSI may also be used in other trading contexts, such as Forex and cryptocurrency markets.
How Does StochRSI Work?
StochRSI is a technical analysis indicator generated from the standard RSI by applying the Stochastic Oscillator formula. The result is a single numerical rating oscillating around a centerline (0.5) and within a range of 0 to 1. However, some versions of the StochRSI indicator multiply the result by 100, making the values range between 0 and 100. The StochRSI is commonly displayed along with a 3-day simple moving average (SMA) acting as a signal line to avoid false signals.
Unlike the standard Stochastic Oscillator formula, which uses an asset's closing price and its highest and lowest points within a set period, the StochRSI formula is directly applied to RSI data without considering prices. The most commonly used time setting for StochRSI is 14 periods, based on the chart time frame. For instance, a daily chart considers the past 14 days, while an hourly chart generates the StochRSI based on the last 14 hours. The number of periods varies among traders, depending on their strategy and profile. A 20-period setting is also a popular option for the StochRSI.
StochRSI values range from 0 to 1 in standard charts, while in some charts, they range from 0 to 100. The centerline is 50 in 0-100 charts, and overbought and oversold signals occur at 80 and 20, respectively. Although charts with a 0-100 setting may look slightly different, the practical interpretation remains the same.
How to Use StochRSI?
The StochRSI indicator is a valuable tool in identifying potential entry and exit points and price reversals. Its significance lies in readings closer to the upper and lower bounds of the range, mainly when the indicator shows that an asset is overbought or oversold. A reading of 0.2 or lower indicates oversold, while a reading of 0.8 or higher suggests overbought. Readings closer to the centerline can also provide helpful information regarding market trends. If the centerline is a support and the StochRSI lines stay above the 0.5 level, it could signal a bullish or upward movement, particularly if the lines move toward 0.8. Conversely, readings persistently below 0.5 and trending toward 0.2 indicate a bearish or downward trend.
StochRSI vs. RSI
Traders use both StochRSI and RSI to identify overbought and oversold conditions, as well as reversal points. RSI is a standard metric that measures the rate and degree of asset price change within a set period. However, compared to the StochRSI, it is slow-moving and produces fewer signals. The StochRSI, generated by applying the Stochastic Oscillator formula to the RSI, is much more sensitive and makes many more trading signals. While this volatility can help traders identify more market trends and potential buying/selling points, it also increases the risks associated with false alerts. To address this, a common method is to apply simple moving averages (SMA), with the default setting being a 3-day SMA for the StochRSI.
The Stochastic RSI, with its high speed and sensitivity, is an invaluable tool for traders, analysts, and investors looking to analyze the market, regardless of whether their analysis is short or long-term. That being said, the increased sensitivity of this indicator means that it generates more signals, which results in more risk. Therefore, it is essential to combine StochRSI with other technical analysis tools to validate its signals. Furthermore, it is crucial to remember that the cryptocurrency market is inherently more unstable than traditional markets, which may produce more false signals.