If you are in trading for a while, chances are you must have heard the terms Relative Strength Index (RSI) and Stochastic oscillators. Both the oscillators are popular among traders to understand momentum and overbought or oversold conditions. Today you are going to learn about another oscillator, which is a hybrid of the two oscillators- the Stochastic RSI (StochRSI).
So, what is StochRSI?
StochRSI is basically indicator of an indicator. Instead of applying price data to Stochastic, StochRSI applies the formula to RSI values. In other words, it measures the position of RSI relative to its own high and low range over a specified period (usually 14). This makes StochRSi much more sensitive than RSI but smoother than Stochastic.
StochRSI is especially popular among short-term and swing traders as it enables them to catch small price moves and early reversals. But this added sensitivity comes with a price- false signals. This is what beginners should be aware of.
Difference between RSI, Stochastic and StochRSI
RSI- RSI measures price momentum based on recent gains and losses.
Stochastic- Stochastic compares a price's closing level relative to a range (high and low) over a period.
StochRSI- StochRSI applies the stochastic formula to RSI values instead of price.
I have written separate posts on RSI and Stochastic oscillators on this blog- Unlocking RSI: Trader's guide to smarter signal and Stochastic Oscillator- what it is, how does it work and how to use it? You can go through these articles if you don't have a prior idea about these indicators.
In this post, we will go step by step through StochRSI calculation, interpretation, uses and limitations, and some beginner tips.
So, let's get started.
How to calculate Stochastic RSI (step by step)
At first, the calculation of StochRSI might appear complicated to beginners, but once you break it down, it becomes easier to comprehend.
Let's go through it step by step.
Formula of Stochastic RSI
The formula to calculate Stochastic RSI is-
StochRSI = RSI - Lowest RSI / Highest RSI - Lowest RSI
where,
RSI = RSI value at current period
Lowest RSI = Lowest RSI value over a chosen period usually 14
Highest RSI = Highest RSI value over a chosen period usually 14
This formula gets the value of %K line of StochRSI. There is another line in the StochRSI plot- the %D line. The %D line of Stoch RSI is calculated by getting average of %K over a specified period, usually 3.
Now that you have a basic idea about calculation of StochRSI, let's now move on to next part- interpretation of StochRSI.
How to read and interpret Stochastic RSI?
Stochastic RSI Value range-
When applying the formula, the resulting StochRSI values will be between 0 and 1.. But some charting softwares like, TradingView, multiply this value by 100 making a new range of 0 to 100. In this post, I will use 0 - 100 range to show interpretation and uses of StochRSI.
Overbought and oversold levels on StochRSI-
StochRSI above 80- StochRSI above 80 indicates the stock is overbought and chances of a potential reversal or a correction in price
StochRSi below 20- StochRSI below 20 suggests the stock is in oversold zone and upside reversal or a correction in price is on the horizon.
See the chart below to understand how StochRSI looks in a chart and how to interpret it.
Bear in mind though that these levels are not buy and sell signals as StochRSI can remain in overbought and oversold regions for long when the upside or downside trend is strong. However, these levels should caution you of a probable reversal or correction in prices. More on it later in the article when we discuss the practical uses of StochRSI.
Bullish and Bearish signals on StochRSI-
Bullish Signal-
When StochRSI crosses above 20 from below it is a bullish signal, however, a confirmation from price action and other indicators must be taken before opening a trade on this signal.
Bearish Signal-
When StochRSI crosses below 80 from above, it indicates a bearish signal, although one should look for confirmation from price action and other indicators before opening a trade.
Let's see this in a chart.
Trend and momentum confirmation through StochRSI-
If StochRSI stays above 50 it confirms a strong momentum in an uptrend while StochRSI below 50 suggests a bearish momentum in a downtrend.
Now that we have got an idea about interpretation of Stochastic RSI, let's now move on to next part- the practical uses of Stochastic RSI.
Practical uses of Stochastic RSI in trading-
Like all other indicators StochRSI should not be used in isolation. Combining this oscillator with price action and other indicators augments your chances of a winning trade. Let's understand a few ways Stochastic RSI is used in trading.
Oversold Bounce and Overbought Drop-
When StochRSI goes below 20 and then comes above this level, traders often expect a short term rally on the upside (oversold bounce). Similarly, StochRSI going above 80 and then coming below that level suggests a short term rally on the downside is in offing (overbought drop).
That said, relying only on this signal might cause whipsaws. This signal must be combined with other signals for confirmation. One way to do this is through MACD indicator. MACD above 0 suggests and uptrend and below 0 suggests a downtrend. By aligning trades with overall trend ups your chances of successful trade. For example, if MACD is above 0 you take only buy trades from StochRSI, that is, oversold bounce and conversely if MACD is below 0 you take only sell signals from StochRSI, that is, overbought drop.
Let's see this in a chart.
StochRSI with Moving average-
Short term traders and swing traders often use the combination of StochRSI and Moving average to get gains from price swings within a trend.
A 50 period MA is plotted to ascertain trend direction and then take buy or sell signals from StochRSI that aligns with the trend.
For example, a 50 period MA sloping up and price above the MA suggests a strong uptrend. In such a situation, traders only take buy when StochRSI moves above 20 from below. The reverse is true for a downtrend. This enables trader to take early entry in a correction with in a trend.
Let's understand this with the help of a chart.
Stochastic RSI divergences-
Just like RSI and MACD you can look for divergences in StochRSI. A divergence between price and StochRSI can be bullish and bearish divergence. A bullish divergence occurs when price makes a lower low but StochRSI makes a higher low. This suggests the ongoing downside momentum is weakening and there is probability of a reversal. Similarly, a bearish divergence occurs when price makes a higher high and StochRSI makes a lower high. Bearish divergence indicates the ongoing upside movement is losing steam and a reversal is on the cards.
Once you spot a divergence, you should be ready to take cues from price action or other indicators to make an entry. For example, if you see a head and shoulders pattern alongwith divergence you should enter the trade once the price breaks the neckline. Another way to make entries following a divergence is by spotting a MA crossover following a divergence.
Let's understand this with the help of a chart.
While StochRSI is an useful tool to make precise entries and exits in a trade it is not free from flaws. In the next section we would learn certain conditions when StochRSI doesn't work.
Limitations of Stochastic RSI
No indicator is perfect and StochRSI is not an exception. In certain situation this indicator might give false signals and you should be aware of that. Here are some conditions when StochRSI might not work as desired.
- In choppy market condition- StochRSI is designed to be more sensitive that the RSI, so, during sideways trends this indicator might generate many false signals.
- In volatile market conditions- During periods of higher volatility this indicator might oscillate erratically between the overbought and oversold levels generating false signals and leading to losses.
- Low volume stocks- The price of low volume stocks tends to move erratically. In such situation StochRSI must not be used.
- Strong trending markets- In strong trending markets StochRSI remains in overbought and oversold conditions for longer periods. This might mislead beginners.
Key Takeaways-
The Stochastic RSI (StochRSI) is a momentum oscillator that blends the strengths of RSI and Stochastic, making it more sensitive to price changes and useful for short-term traders. It helps identify overbought/oversold zones, spot potential reversals, confirm trend momentum, and even detect divergences. However, its sensitivity can also lead to false signals, especially in choppy, volatile, or strongly trending markets. For best results, traders should always use StochRSI in combination with other tools such as price action, moving averages, or MACD to filter out noise and improve accuracy.
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