Technical Indicators Explained: How Does Stochastic RSI Work?

Bitcoin is rewriting history in terms of valuations, growing two-fold in as little as a month. The tremendous growth in Bitcoin and altcoins has spurred an army of new traders ready to dive into crypto trading. While most traders jump straight into the action, it’s always worthwhile to understand how technical indicators like Stochastic Relative Index (RSI) works. And how it helps you to open positions at the right time.

So, if you’re still curious, you can leverage this indicator to identify market trends. Let’s take a granular look at this technical indicator and its utility in crypto trading.

What Is Stochastic RSI?

Stochastic RSI considers the relative strength index (RSI) and applies stochastic oscillator formula to it, deriving market trends that are more sensitive than RSI alone. It is a technical indicator built through the combination of stochastic oscillator formula and relative strength index (RSI) and ranges between 0 to 100.

Stochastic RSI allows traders to identify whether an asset is in the overbought (80) or oversold (20) territory.

Of course, you’re excited to know how it works, but let’s first understand the fundamentals.

Since Stochastic RSI is derived from RSI itself, it makes absolute sense to understand the concept. Basically, the RSI is a technical indicator that tracks an asset’s momentum, identifying whether the cryptocurrency is overbought or oversold.

Typically the RSI is measured between 0 to 100, with values above 70 indicating overbought and values below 30 reflecting oversold positions. The upshot? It represents a signal for the direction and the strength of the trend.

A trader would usually make buy or sell signals based on the RSI crosses of 70 and 30. But if you’re your buying decision relies only on this theory, you’re only going to LOSE MONEY. That’s because the stock market, and not to mention cryptocurrency, never favor the obvious trade.

In fact!

RSI alone gives limited buy or sell signals, missing critical entry or exit points for intraday trading.

On the contrary, Stochastic RSI is more sensitive to market movements, allowing traders to find multiple entry/exit signals. However, it is still critical to combine stochastic RSI with other technical indicators to avoid early/late sell or buy calls.

So, How Does Stochastic RSI Work?

Stochastic RSI considers the RSI index’s movements within a given period without emphasizing the current price levels. The most popular calculation period is 14 periods (14 days, sessions, hours, or even minutes).

The result is a figure between 0 to 1, swinging with a centerline of 0.5. It is essential to note that some Stoch RSI calculators multiply the output with 100, providing readings in the range of 0 to 100. Another popular calculation period for Stoch RSI is 20 periods.

But, it’s all down to how the calculation. And how you can interpret the readings to identify whether the current RSI value is overbought or oversold.

Stochastic RSI Formula

Stochastic RSI uses RSI as its base. The formula is as shown:

Stoch RSI= (Current RSI – Lowest RSI)/ (Highest RSI – Lowest RSI)

Where:

• The lowest RSI refers to the reading over the last 14 periods (or chosen lookback period)
• The highest RSI refers to the reading over the last 14 period (or lookback period).

It is critical to understand that Stoch RSI can be applied to any time frame to identify price movements or market trends. You can use this formula for different trading periods, including days, hours, or even minutes. And they are mostly used to improve sensitivity and generate a more significant number of signals than traditional indicators.

How Does Stochastic RSI Looks Like?

Stochastic RSI takes RSI as its input and applies the stochastic oscillator formula to arrive at a figure between 0 and 1 for any given period.

Below is a pictorial representation of the indicator.

Crypto traders who use Stochastic RSI can select any period and analyze the movement of a crypto asset. We’ll take a more in-depth look into the different ways traders use Stochastic RSI in the coming sections.

But first, you need to understand the complications of the Stochastic and RSI. While they sound similar, but there’s indeed a difference.

Stochastic vs. Stochastic RSI

So, why do I need a Stochastic RSI indicator when there’s already a Stochastic Oscillator and RSI.

Well, one of the main reasons is because the Stochastic Oscillator formula is the former’s sensitivity. Hence, leading to more buy or sell signals. That means it works best for assets that exist in a volatile market like cryptocurrencies.

In other words, the stochastic oscillator formula works best when the market is trading in a consistent range. But with the combination of RSI to measure the speed of price movements.

If you still think they’re the same, then you’re WRONG!

Here’s the highlights of their differences:

• The base of measurement: Stochastic Oscillator uses the closing price of a crypto asset as its base, whereas StochasticRSI uses RSI as its base. It’s imperative to understand that StochasticRSI may lag more than Stochastic Oscillator as it uses RSI as its input.

• Measurement scale: Stochastic Oscillator uses a value between 0 and 100 for tracking the market momentum. While, StochasticRSI has a scale of 0 to 1, with 0.5 acting as its centerline.

• The number of signals: StochasticRSI is more sensitive to the market movements and provides more oversold/overbought signals than Stochastic Oscillator. A crypto trader needs to know a sign to trade at and which to avoid.

  
  

Refers to the chart for the differences between Stochastic and Stochastic.

The main five points to keep in mind are as follow:

• The Stochastic RSI is more sensitive to the actual changes in the crypto asset price than the original Stochastic indicator. As a result, the Stochastic RSI is more volatile, which means it moves more between overbought and oversold readings and vice versa (see number 3 on the chart).
• Secondly, this indicator tends to reach overbought and oversold readings more rapidly than the original Stochastic (see number 1 on the chart).
• Stochastic RSI is more prone to generate false overbought and oversold signals than the original Stochastic indicator (see number 4 on the chart).
• It is better at pinpointing short-term trade signals because it’s more sensitive to recent price changes in a crypto asset.
• When it comes to a strong trending market, the Stochastic RSI can pinpoint the end of a pullback much accurately because, during a strong trend, the market has shallow and faster pullbacks. In this trading scenario, finding an entry on a pullback with the original Stochastic indicator is not that easy to identify (see number 2 on the chart).

While the fundamentals can go on and on, it is most important to understand how to use them.

How to Use Stochastic RSI: Explained

StochRSI can be used for different occasions, and it’s commonly used to interpret a trading signal.

In this chapter, you’ll learn how to use Stochastic RSI to interpret the trading signals and understand the strategies to apply the indicator strategically.

Interpret The Trading Signals

One of the primary uses of Stochastic RSI is to identify trading signals. Here is how a trader can use StochRSI to interpret the movements of a cryptocurrency.

• Buy signal: Any reading below 0.2 is the oversold range, which means as StochRSI moves above 0.2, the trader can consider it as a buy signal.
• Sell signal: If the reading crosses below 0.8 line, the cryptocurrency is witnessing a reversal from an overbought state. This is the right time to sell the crypto asset.
• Trend reversal: Traders can also use StochRSI as an indicator of ongoing pricing trends for a cryptocurrency and adjust their strategy accordingly.

Identify The Overbought/Oversold Signals

• Overbought signals: If the StochRSI of a cryptocurrency breaches 0.8-mark and stays above this line, it is in the oversold region. Traders seeking quick returns may want to close their positions. At the same time, traders can apply a shorting strategy as the value dips below 0.8.
• Oversold signals: When the StochRSI dips below 0.2, the cryptocurrency is in the oversold region. The prices are close to the lowest levels during the chosen period, giving the right opportunity for buying (once it goes above 0.2).

Day Trading with Stochastic RSI

Since Stochastic RSI allows traders to identify overbought or oversold conditions, it works as an excellent tool for identifying the market momentum.

Traders can use this indicator to:

• Identify and short-term trader trends: Under this strategy, traders should pay attention to the centerline (0.5); any movement above 0.5 indicates an uptrend, whereas movements below 0.5 indicate a bearish trend. Traders can place buy triggers as the value goes above 0.5. Similarly, day traders can use a short-sell or sell as the oscillator moves below the 0.5 level.
• Spot price reversals: Crypto markets are notorious because of their volatility. Intraday trading in crypto requires a trader to identify any price reversals instantly to avoid significant losses. Traders can use Stochastic RSI to identify any such price reversals and open or close positions accordingly. It is advised to use divergence and convergence as additional indicators when trading on price reversals.

Day Trading Strategy Examples

We are going to present an example using this technical indicator for day trading. This will help you incorporate the principle taught here into your own day trading strategy.

For example:

Assuming you have been trading for several days in a well-defined uptrend, printing Stochastic RSI readings between 50 and 100. The idea is that when the oscillator holds above the 50 levels, the bulls are in control of the market. You can definitely increase the edge of any day trading strategy by going with the trend.

The Stochastic RSI bouncing between the 50 and 100 level is NOT an actionable signal in and of itself. So, we lower our time frame to the 5-minute chart for entry signals. Then, wait for significant oversold signals to time the market.

Since the predominant trend is bullish, any short-term oversold reading can signal the end of a short-term correction and the uptrend’s resurrection.

As we reduce the time frame to time the market, the Stochastic RSI might be prone to many false signals. In this regard, it’s safer to enter the market once the Stochastic RSI bounces from oversold readings and crosses above the 50 levels on the way up. Meanwhile, the protective stop loss level can be safely placed below the lowest low of the bearish pullback.

To increase the odds of a winning trade, you can always combine more than one technique like price action, candlestick patterns, and confirmation from other indicators.

The Pros

• More buy or sell signals: Stochastic RSI, in comparison to RSI, provides more buy or sell signals because of its higher sensitivity. If used the right way, crypto traders can identify multiple trading opportunities.
• Indicator of market momentum: For traders planning daily strategies, Stochastic RSI can help identify the momentum, thereby allowing traders to prepare a strategy accordingly.
• Identify short pullbacks, upward trends for scalping: The primary idea behind scalping is to benefit from short-term movements in a cryptocurrency price. Stochastic RSI allows traders to spot short-term pullbacks, creating an ideal opportunity for scalping. However, it is crucial to use this indicator with other technical indicators to confirm the market momentum. A strong upward or downward trend may witness a breach of these established prices.

The Limitations

• Distant from the real price of cryptocurrencies: Unlike RSI, which takes the price of a crypto asset as the base for its calculation. Stochastic RSI uses RSI as its base, putting it two levels away from the actual price of the cryptocurrency. It is quite possible to witness a higher disconnect between the prices and the readings. In some cases, the traders may notice a slight lag.
• Higher volatility: Which the primary use of this indicator is to find more buying or selling positions; this could be a shortcoming for new crypto-traders. It is advisable to use the stochastic RSI strategy in conjunction with other technical parameters.

Closing Thoughts

Stochastic RSI has its benefits as well as limitations. Using it in conjunction with other indicators (DMA, support-resistance indicator) could help traders create an effective trading strategy. However, it’s not advisable to use it alone because of higher volatility and distant relation with the current asset prices.