Relative Strength Index vs. Stochastic Oscillator

Relative strength index (RSI) and stochastic oscillator are both price momentum oscillators that are used to forecast market trends. Despite their similar objectives, the two indicators have very different underlying theories and methods. The stochastic oscillator is predicated on the assumption that closing prices should close near the same direction as the current trend. RSI tracks overbought and oversold levels by measuring the velocity of price movements. More analysts use RSI over the stochastic oscillator, but both are well-known and reputable technical indicators.

Relative Strength Index

J. Welles Wilder Jr. developed relative strength index by comparing recent gains in a market to recent losses. In this way, RSI is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset.

Key Takeaways

  • RSI and stochastics are both momentum oscillators, but with notable differences between the two indicators.
  • Created by J. Welles Wilder, RSI measures recent gains against recent losses.
  • Stochastic oscillators or stochastics are based on the idea that closing prices should confirm the trend.
  • Both RSI and stochastics are used as overbought/oversold indicators, with high readings suggesting an overbought market and low readings indicative of oversold conditions.

RSI is typically displayed as an oscillator (a line graph that moves between two extremes) along the bottom of a chart and can have a reading from 0 to 100. The midpoint for the line is 50. When RSI moves above 70, the underlying asset is considered to be overbought. Conversely, the asset is considered oversold when the RSI reads below 30. Traders also use the RSI to identify areas of support and resistance, spot divergences for possible reversals, and to confirm the signals from other indicators.

Stochastic Oscillators

George Lane created stochastic oscillators, which compare the closing price of a security to a range of its prices over a certain period of time. Lane believed that prices tend to close near their highs in uptrending markets and near their lows in downtrending ones. Like RSI, stochastic values are plotted in a range between 0 and 100. Overbought conditions exist when the oscillator is above 80, and the asset is considered oversold when values are below 20.

Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session, and one reflecting its three-day simple moving average. Because price is thought to follow momentum, the intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum from one day to the next.

Divergences between the stochastic oscillator and trending price action is also seen as an important reversal signal. For example, when a bearish trend reaches a new lower low, but the oscillator prints a higher low, it may be an indicator that bears are exhausting their momentum, and a bullish reversal is brewing. Similarly, divergences between RSI and price are considered significant as well.

The Bottom Line

While relative strength index was designed to measure the speed of price movements, the stochastic oscillator formula works best when the market is trading in consistent ranges. Generally speaking, RSI is more useful in trending markets, and stochastics are more useful in sideways or choppy markets.

Article Sources
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  1. The Trader's Journal. "Interview With J. Welles Wilder," Page 9.

  2. CMT Association. "Origins of the Stochastic Oscillator."

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