What Is the Stochastic RSI?
The Stochastic RSI (StochRSI) is an indicator used in technical analysis that ranges between zero and one (or zero and 100 on some charting platforms) and is created by applying the Stochastic oscillator formula to a set of relative strength index (RSI) values rather than to standard price data. Using RSI values within the Stochastic formula gives traders an idea of whether the current RSI value is overbought or oversold.
The StochRSI oscillator was developed to take advantage of both momentum indicators in order to create a more sensitive indicator that is attuned to a specific security's historical performance rather than a generalized analysis of price change.
- A StochRSI reading above 0.8 is considered overbought, while a reading below 0.2 is considered oversold. On the zero to 100 scale, above 80 is overbought, and below 20 is oversold.
- Overbought doesn't necessarily mean the price will reverse lower, just like oversold doesn't mean the price will reverse higher. Rather the overbought and oversold conditions simply alert traders that the RSI is near the extremes of its recent readings.
- A reading of zero means the RSI is at its lowest level in 14 periods (or whatever lookback period is chosen). A reading of 1 (or 100) means the RSI is at the highest level in the last 14 periods. Other StochRSI values show where the RSI is relative to a high or low.
The Formulas For the Stochastic RSI (StochRSI) are
RSI = Current RSI reading;
Lowest RSI = Lowest RSI reading over last 14 periods (or chosen lookback period); and
Highest RSI = Highest RSI reading over last 14 period (or lookback period).
How to Calculate the Stochastic RSI
The StochRSI is based on RSI readings. The RSI has an input value, typically 14, which tells the indicator how many periods of data it is using in its calculation. These RSI levels are then used in the StochRSI formula.
- Record RSI levels for 14 periods.
- On the 14th period, note the current RSI reading, the highest RSI reading, and lowest RSI reading. It is now possible to fill in all the formula variables for StochRSI.
- On the 15th period, note the current RSI reading, highest RSI reading, and lowest reading, but only for the last 14 period (not the last 15). Compute the new StochRSI.
- As each period ends compute the new StochRSI value, only using the last 14 RSI values.
What Does the Stochastic RSI Tell You?
The StochRSI was developed by Tushar S. Chande and Stanley Kroll and detailed in their book "The New Technical Trader," first published in 1994. While technical indicators already existed to show overbought and oversold levels, the two developed StochRSI to improve sensitivity and generate a greater number of signals than traditional indicators could do.
The StochRSI deems something to be oversold when the value drops below 0.20, meaning the RSI value is trading at the lower end of its predefined range, and that the short-term direction of the underlying security may be nearing a low a possible move higher. Conversely, a reading above 0.80 suggests the RSI may be reaching extreme highs and could be used to signal a pullback in the underlying security.
Along with identifying overbought/oversold conditions, the StochRSI can be used to identify short-term trends by looking at it in the context of an oscillator with a centerline at 0.50. When the StochRSI is above 0.50, the security may be seen as trending higher and vice versa when it's below 0.50.
The StochRSI should also be used in conjunction with other technical indicators or chart patterns to maximize effectiveness, especially given the high number of signals that it generates.
In addition, non-momentum oscillators like the accumulation distribution line may be particularly helpful because they don't overlap in terms of functionality and provide insights from a different perspective.
The Difference Between the Stochastic RSI and the Relative Strength Index (RSI)
They seem similar, but the StochRSI relies on a different formula from what generates RSI values. RSI is a derivative of price. Meanwhile, stochRSI is derivative of RSI itself, or a second derivative of price. One of the key differences is how quickly the indicators move. StochRSI moves very quickly from overbought to oversold, or vice versa, while the RSI is a much slower moving indicator. One isn't better than the other, StochRSI just moves more (and more quickly) than the RSI.
Limitations of Using the Stochastic RSI
One downside to using the StochRSI is that it tends to be quite volatile, rapidly moving from high to low. Smoothing the StochRSI may help in this regard. Some traders will take a moving average of the StochRSI to reduce the volatility and make the indicator more useful. For example, a 10-day simple moving average of the StochRSI can produce an indicator that's much smoother and more stable. Most charting platforms allow for applying one type of indicator to another without any personal calculations required.
Also, the StochRSI is the second derivative of price. In other words, its output is two steps away from the actual price of the asset being analyzed, which means at times it may be out of sync with an asset's market price in real time.