Stochastic RSI, or simply StochRSI, is a technical analysis indicator used to determine whether an asset is overbought or oversold, as well as to identify current market trends. As the name suggests, the StochRSI is a derivative of the standard Relative Strength Index (RSI) and as such is considered an indicator indicator. It is a type of oscillator, meaning it fluctuates above and below a center line.

StochRSI was first described in the 1994 book The New Technical Trader by Stanley Kroll and Tushar Chande. It is frequently used by stock market traders, but can also be applied to other trading contexts, such as the Forex and cryptocurrency markets.


How does StochRSI work?

The StochRSI indicator is generated from the ordinary RSI by applying the stochastic oscillator formula. The result is a single numerical rating that oscillates around a central line (0.5), in a range of 0-1. However, there are modified versions of the StochRSI indicator that multiply the results by 100. So the values ​​are between 0 and 100 instead of 0 and 1. It is also common to see a simple moving average (SMA) at 3 days coupled with the StochRSI line, which serves as a signal line and aims to reduce the risks of trading on false signals.

The standard stochastic oscillator formula takes into account an asset's closing price as well as its highest and lowest points during a given period. However, when the formula is used to calculate StochRSI, it is directly applied to the RSI data (prices are not taken into account).

Stoch RSI = (Current RSI - Lowest RSI)/(Highest RSI - Lowest RSI)

Just like the standard RSI, the most commonly used time setting for the StochRSI is 14 periods. The 14 time periods involved in calculating StochRSI are based on the chart's time unit. So, while a daily chart takes into account the last 14 days (candlesticks), an hourly chart generates the StochRSI based on the last 14 hours.

Periods can be defined in days, hours or even minutes, and their usage varies greatly from trader to trader (depending on their profile and strategy). The number of periods can also be adjusted up or down to identify longer-term or shorter-term trends. A 20 period setting is another fairly popular option for the StochRSI indicator.

As mentioned earlier, some StochRSI chart templates assign values ​​ranging from 0 to 100 instead of 0 to 1. On these charts, the midline is at 50 instead of 0.5. Therefore, the overbought signal that usually occurs at 0.8 would be rated at 80 and the oversold signal at 20 rather than 0.2. Charts with a 0-100 setting may look slightly different, but the practical interpretation is essentially the same.


How to use StochRSI?

The StochRSI indicator takes on its full significance near the upper and lower limits of its range. Therefore, the indicator is primarily used to identify potential entry and exit points, as well as price reversals. So, a reading of 0.2 or lower indicates that an asset is likely oversold, while a reading of 0.8 or higher suggests that it is likely to be overbought.

Additionally, readings closer to the midline can also provide useful insights into market trends. For example, when the midline acts as support and the StochRSI lines consistently place above the 0.5 mark, this can suggest the continuation of an uptrend or uptrend - especially if the lines begin to move towards 0.8. Likewise, values ​​consistently below 0.5 and a trend toward 0.2 indicate a downtrend.


StochRSI vs. RSI

The StochRSI and RSI indicators are band oscillator indicators that make it easier for traders to identify potential overbought and oversold conditions, as well as possible turning points. In short, standard RSI is a metric used to track how quickly and to what extent an asset's prices are changing in relation to a given time period.

However, compared to the Stochastic RSI, the standard RSI is a relatively slow indicator that produces a small number of trading signals. Applying the stochastic oscillator formula to the normal RSI allowed the creation of the StochRSI as an indicator with increased sensitivity. Therefore, the number of signals it produces is much higher, giving traders more opportunities to identify market trends and potential buy or sell points.

In other words, StochRSI is a fairly volatile indicator. While this makes it a more sensitive technical support tool that can help traders with an increased number of trading signals, it is also riskier because it often generates a significant amount of noise (false signals). As mentioned earlier, applying simple moving averages (SMA) is a common method to reduce the risks associated with these false signals and in many cases a 3-day SMA is already included as a default setting for the indicator StochRSI.


Conclusion

Due to its greater speed and sensitivity to market movements, Stochastic RSI can be a very useful indicator for analysts, traders and investors - for both short and long term analysis. However, more signals also means more risk and, for this reason, StochRSI should be used alongside other technical analysis tools that can help confirm the signals it creates. It is also important to keep in mind that cryptocurrency markets are more volatile than traditional markets and, as such, may generate an increased number of false signals.