Introduction
It can be quite interesting to see the numerous different kinds of indicators within the stock market. After all, there tends to be a lot of complexities associated with how these markets behave, enough to overwhelm any newcomer.
Indicators therefore seek to make the world of stocks, securities, bonds, etc., more accessible and capable of identifying, or predicting, all kinds of trends, price volatility, and more. One such indicator we’ll be looking at today is the stochastic RSI (Relative Strength Index).
What is StochRSI (Stochastic RSI)?
So what is Stochastic RSI all about? Well, firstly, it’s a technical indicator that has greatly influenced how technical-minded investors assess market momentum.
Although it might sound a bit like this arcane financial jargon, the tool has been known for predicting some rather significant market moves—at times even days before they happen.
Stanley Kroll and Tushar S. Chandeare the men behind the development of the StockRSI, which they first detailed within their book called “The New Technical Trader” in 1994.
The Purpose of Stochastic RSI
The StockRSI is supposed to be an improved iteration of the widely-known RSI. By introducing the stochastic oscillator formula within RSI values, the StochRSI seeks to offer a more nuanced take on oversold and overbought conditions for financial assets.
Within an age where algorithmic trading is the norm with market volatility instantly spiking up, such tools can be part of an enormous arsenal that retail and institutional investors may use to navigate challenging market waters.
owadays, such instruments make navigation akin to possessing an advanced GPS instead of having star charts like people in the earlier centuries did.
All in all, it’s more sensitive to trends when compared to the RSI, and, like it, it’s capable of identifying trend reversals.
How is Stochastic RSI Calculated?
While you won’t really need to calculate those stochRSI values yourself, as most trading platforms supporting it will already do it for you, knowing how the calculations work will grant you some additional insights into how the indicator works, which may help you later on in your trading journey.
Formula for Stochastic RSI
So without further ado, here’s the formula for the StochRSI:
StochRSI = RSI – min (RSI)/max (RSI) – min (RSI)
Key Parameters of Stochastic RSI
We went over the formula earlier, but what do those parameters really mean? First, since this indicator is derived from the RSI, naturally the RSI within this formula includes the stock’s current RSI readings.
As for min (RSI), that would be the lowest RSI reading spanning the previous 14 periods, or whatever you choose your lookback interval or period to be.
Compared to this, the max (RSI) is basically the same except that it includes the highest RSI readings.
How to Use Stochastic RSI in Trading
So, now that you know what the StochRSI is supposed to accomplish, you might be curious about how you may use it in trading. If that’s the case, then you’re in luck, as we’ll be looking at that below.
Overbought and Oversold Conditions
Although technical indicators showing oversold and overbought levels or other conditions determining whether prices are rising or falling have already existed, StochRSI was developed to enhance sensitivity and produce even more signals than conventional indicators were capable of.
And unlike the RSI itself, the stochastic RSI values range between 0 and 1.
So, the stochRSI deems oversold conditions if the value hits below 0.30, implying that the RSI value has been trading at that lower end of the predetermined range and an increased likelihood of the underlying security’s short-term direction nearing potential move higher or lower.
In contrast, readings over 0.70 convey the exact opposite in that the RSI could be reaching extreme heights and it may be used as a pullback signal for the underlying stock.
Stochastic RSI Crossovers
The stochastic RSI may even be utilized to identify the crossovers between the signal and indicator lines. Traders could then use these crossovers to engage in some informed decision-making regarding when to exit or enter positions.
For instance, if the StochRSI heads over its signal line, a bullish signal may be implied, with a crossover under the signal line indicating upcoming bearish sentiments.
Stochastic RSI Divergence
Stochastic RSI might even identify divergences between price and the indicator. If a stock’s price is generating higher highs but you see the stochRSI producing lower highs, then it could suggest a bearish divergence.
Likewise, if you see a security’s price generating lower lows but the stochRSI is producing higher lows, then you might have a bullish divergence on your hands. Traders could then use such divergences to come up with more informed decisions about their trades.
Stochastic RSI Strategies for Different Trading Styles
In this section, we’ll go over how the StochRSI relates to the more common trading styles out there, namely day, swing, and long-term trading.
Day Trading with Stochastic RSI
Since day trading typically focuses on short-term gains, the time frames for the StochRSI can be adjusted accordingly to suit whatever day traders require.
One strategy that day traders may use while incorporating the stochRSI indicator would have to be scalping reversals, as the strategy practically demands entering a lot of positions within a relatively short period of time, making the most use out of trend reversals.
Swing Trading with Stochastic RSI
For swing trading, which primarily focuses on medium-to-long-term profitability, traders might be able to make more use out of the StochRSI since they’re giving themselves more time to work in. So, like day traders, they can change the time frames as they see fit and benefit more from strategies involving crossovers.
Long-Term Investing with Stochastic RSI
For the long-term traders, i.e., those who are in for the long haul, the StochRSI indicator can be just what they’re looking for in that they can change the time frames to reflect what they want to achieve with their trading goals.
Because of the sheer amount of time they have allocated to their objectives, they might find divergence strategies associated with this indicator particularly welcoming.
Advantages and Limitations of Stochastic RSI
Similar to any other indicator out there, the stochRSI comes with its own share of pros and cons, and understanding them before engaging with the tool will help you make the most out of your trading endeavors.
Benefits of Using Stochastic RSI
Well, to start with the benefits, it is obvious how sensitive it is to trends, and because of that, it’s able to more clearly indicate overbought and oversold conditions.
Not only that, but its time frames are flexible in their accommodation to various traders and trading styles, potentially broadening their arsenal and what they can do with the resources they possess.
Limitations of Stochastic RSI
But on to the downsides now. Firstly, anyone using the stochRSI will sooner or later notice that it’s quite volatile, as it rapidly undergoes highs and lows.
In this regard, smoothing the stochRSI could help. For instance, some traders may take an MA of the indicator itself to lower the volatility and possibly make it even more useful.
A 10-day simple moving average, or SMA for short, can generate an indicator that’s considerably more stable and smooth. In fact, many platforms already enable the application of one kind of indicator to another without personally calculating values yourself.
Additionally, the stochastic RSI is like the price’s second derivative. To elaborate, its output is like two steps behind the asset’s actual price, and this means that it may not be in sync with market prices in real time. This further means that the potential for false signals is really there.
Also, the fact that it’s a second derivative and a lagging indicator on top of that means that it may not be ideal for strong markets with high volatility rates.
Conclusion
StochRSI is basically another iteration of the conventional RSI that improves sensitivity while offering more frequent trading signals.
Here, with the application of the stochastic oscillator within the values acquired from the relative strength index, you’re essentially getting a tool that can be good for identifying oversold and overbought conditions within the market and more.
What is the difference between Stochastic RSI and traditional RSI?
The main differences include the sensitivity, speed, and frequency of trading signals. The stochastic RSI is generally faster, more sensitive, and more frequently generates signals.
What are the best settings for Stochastic RSI?
The best settings are largely dependent on what trading style you prefer. Many traders tend to be fine with the default settings.
How can I avoid false signals when using Stochastic RSI?
The best way you can avoid false signals is by combining it with another indicator for additional confirmation. You may use the Bollinger Bands, the MACD, SMAs, EMAs, and whatnot.
Can Stochastic RSI be used for all asset classes?
Literally speaking, no, but it can be used for quite a fair chunk of them, mostly stocks, bonds, cryptocurrencies, and various other commodities.
Is Stochastic RSI suitable for trending markets?
Yes, it is suitable, but only to a certain extent, as it may not do well in extremely volatile conditions due to it being a lagging indicator.