What is Stochastic RSI?
The Stochastic Relative Strength Index, abbreviated as StochRSI, is a technical analysis indicator used to determine whether an asset is overbought or oversold, and also to determine the current market dynamics. As the name suggests, the StochRSI is a derivative of the Standard Relative Strength Index (RSI) and is therefore considered to be an index capable of measuring indices. It is an oscillator that fluctuates above and below the center line.
StochRSI was originally described in a 1994 book entitled The NewTechnical Trader by Stanley Kroll and Tushar Chande. It is often used by stock traders and is also applicable to other trading environments such as the forex and cryptocurrency markets.
How does StochRSI work?
The StochRSI is generated from the standard RSI by applying the Stochastic Oscillator Generation formula.The generated result is a single numeric rating that oscillates up and down around the center line (0.5) over a value range of 0–1. However, a modified version of the StochRSI multiplies the result by 100 so that the value is between 0 and 100 rather than 0 and 1. It is also common to refer to the Simple Moving Average (SMA) over a 3-day period, as well as the StochRSI trend, as a signal line designed to reduce the risk of trading false signals.
The standard Stochastic Oscillator Index formula depends on the closing price of the asset as well as the high and low prices within the set period. However, when the formula is used to calculate the StochRSI, it uses the RSI data directly (without taking price into account).
Stoch RSI = (Current RSI — Lowest RSI)/(Highest RSI — Lowest RSI)
Like the standard RSI, the StochRSI uses the most common time period of 14. The 14 periods involved in the StochRSI calculation are based on the chart timeframe. Thus, a daily chart will show the last 14 days (K chart) and an hourly chart will show the StochRSI generated over the last 14 hours.
The periods can be set to days, hours or even minutes and the way they are used varies from trader to trader (depending on their situation and strategy). The number of periods can also be adjusted upwards or downwards to determine long-term or short-term trends. Setting the period value to 20 is a fairly popular option for the StochRSI indicator.
As mentioned above, some StochRSI chart patterns specify a range value of 0 to 100 instead of 0 to 1. In these charts, the center line is 50 instead of 0.5. Therefore, an overbought signal, which usually occurs at 0.8, would be indicated as 80, while an oversold signal would be indicated as 20 instead of 0.2. Charts with a setting of 0–100 may look slightly different, but the actual principle of interpretation is basically the same.
How to use StochRSI?
The StochRSI index is most significant when it appears near the upper and lower limits of its range. Therefore, the main use of this indicator is to identify potential buy and sell points, as well as price reversals that occur. Thus, a value of 0.2 or below would indicate that an asset may be oversold, while a value of 0.8 or above would indicate that the asset may be overbought.
In addition, values closer to the center line can also provide traders with information about market trends. For example, when the center line acts as a support line and the StochRSI line moves steadily above 0.5, especially as the value approaches 0.8, it may indicate a continued bullish or uptrend. Similarly, when the value is consistently below 0.5 and approaching 0.2, it indicates a downward or descending trend.
StochRSI vs RSI
Both the StochRSI and the RSI are banded oscillator indices that make it easier for traders to identify potential overbought and oversold situations, as well as possible price reversal points. In short, the Standard RSI is an index that tracks asset prices and changing trends based on a set time frame (period).
However, compared to the Stochastic RSI, the Standard RSI is a relatively low-variance indicator that generates only a small number of trading signals. The Stochastic Oscillator formula can be used to generate a more sensitive StochRSI index from the Standard RSI. As a result, the number of signals it generates will be much higher, providing traders with more opportunities to identify market trends and potential buy and sell points.
In other words, the StochRSI is a relatively unstable indicator, which also makes it a more sensitive TA tool that can provide traders with more trading signals, but it is also more risky because it often generates a considerable amount of noise (false signals). As mentioned above, utilizing the Simple Moving Average (SMA) is a common way to reduce these false signals and risk, and in most cases, the 3-day SMA has been used as the default setting for the StochRSI indicator.
Concluding thoughts
Since the StochRSI shows more speed and sensitivity to market movements, the indicator can be a very useful indicator for analysts, traders and investors in both the short and long term. However, more trading signals also mean that there is more risk involved, so the StochRSI should be used in conjunction with other technical analysis tools that can assist traders in confirming the signals it generates. It is also important to note that the cryptocurrency market is more volatile than the traditional currency market and therefore may generate more false trading signals.
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