Both the relative strength index (RSI) and stochastic oscillator are price momentum oscillators that are used to forecast market trends. Despite their similar objectives, they 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. The RSI tracks overbought and oversold levels by measuring the velocity of price movements. More analysts use the RSI over the stochastic oscillator, but both are well-known and reputable technical indicators.
Relative Strength Index
J. Welles Wilder Jr. developed the RSI by comparing recent gains in a market to recent losses. It 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. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100 and are plotted on a line underneath the price chart. The midpoint for the line is 50. When the RSI value trends 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 confirm the signals from other indicators.
Stochastic oscillators were created by George Lane. A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to a range of its prices over a certain period of time. The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result. It is used to generate overbought and oversold trading signals.
Lane believed that prices tend to close near their highs in uptrending markets and near their lows in downtrending ones. Like the RSI, stochastic values are plotted in a range bound 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, 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 day to day.
Divergence 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.
The Bottom Line
Generally speaking, the RSI is more useful in trending markets, and stochastics are more useful in sideways or choppy markets. The RSI was designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges.