How do I build a profitable strategy when spotting a Stochastic RSI pattern?

The most common use of the Stochastic RSI (StochRSI) in the creation of trade strategy is to look for readings in the overbought and oversold ranges. The StochRSI fluctuates between 0 and 1, with readings below 0.2 considered oversold and those above 0.8 reflecting overbought conditions. Oversold readings in a large uptrend are considered bullish signals, and overbought readings in a larger downtrend are considered bearish.

However, the heightened volatility of the StochRSI warrants caution. Trade entry should not be made following overbought or oversold readings until subsequent price action confirms the move. For example, overbought readings in a downtrend should be seen as a warning of a potential move rather than as an entry signal. The StochRSI must move back below the centerline at 0.5 to confirm the continued bearish trend. Conversely, the StochRSI must rise above 0.5 following oversold readings in a larger bullish trend. However, StochRSI readings that remain in oversold or overbought territory for an extended period may signal a trend reversal. (For related reading, see "Retracement vs. Reversal: What's the Difference?")

An Example Using StochRSI

Assume a security has been experiencing a pronounced downtrend for a number of weeks, printing RSI readings between 18 and 60. The current session prints an RSI reading of 56. Though this would typically not be considered an actionable RSI reading, the StochRSI calculation tells a different story. The StochRSI for this session is (56 - 18) / (60 - 18), or 0.9. Such a significant overbought signal in a larger downtrend is an indicator that price is likely to resume its fall after the bullish correction.

Once the StochRSI moves back below 0.5, enter a short position using market or limit orders, depending on your preference. The highest high of the bullish retrace serves as a convenient stop-loss. Because bulls tried and failed to push the price beyond this point once already, a move above this level may signal an end to the bearish trend.

Because the StochRSI generates so many signals, both good and bad, it is advisable to seek corroborating evidence of trend continuation from additional indicators. Consistently strong volume and candlestick patterns, such as the falling three methods, strengthen the stochRSI signal. (For related reading, see "What Does the Three Black Crows Pattern Mean?")

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