Stochastic RSI: What Is It and How Does It Work?

Bitcoin is rewriting history in terms of valuations, breaking the resistance of $30,000 as of this writing (June 28, 2023). The recurring 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 technical indicators and tools that can strategize your entry and exit points for each trade. Stochastic RSI is one such indicator, allowing traders to identify market trends.

Let’s take a granular look at this technical indicator and its utility in crypto trading.

Key Takeaways:

• Stochastic RSI was introduced to increase sensitivity to price volatility, in order to more accurately determine an asset’s overbought and oversold levels.

• It uses the foundations of both stochastic and RSI indicators, which adjust to the historical performance of an asset to measure the level of RSI relative to the price movement over a period of time.

• The stochastic RSI indicator is ideal intraday trading and swing trading tool for volatile trading assets such as Bitcoin. 

What Is Stochastic RSI?

Stochastic RSI is a technical indicator built on the foundations of both the stochastic oscillator and relative strength index (RSI) indicator, It ranges on a scale from 0 to 1. Stochastic RSI allows a technical trader to identify whether an asset is in overbought (≥ 0.8) or oversold (≤ 0.2) territory. It takes into consideration both the RSI indicator and stochastic oscillator in order to derive market trends that are more sensitive in comparison to RSI alone. The stochastic RSI indicator (or StochRSI) thrives particularly through its ability to compare an asset's price range and closing price to support its market prediction for price turning points.

Since this indicator is closely related to RSI, it's essential to understand how the two are related. The RSI indicator tracks the momentum of an asset, for example, identifying whether a cryptocurrency is overbought or oversold. It measures in a range between 0 and 100, with values above 70 indicating overbought and values below 30 reflecting oversold positions.

However, RSI alone gives limited buy or sell signals, missing critical entry or exit points for intraday trading. Stochastic RSI, on the other hand, is more sensitive to market movements, allowing traders to find multiple entry/exit signals more granularly. However, it’s critical to combine stochastic RSI with other technical indicators to avoid early/late sell or buy calls.

How Does Stochastic RSI Work?

Stochastic RSI examines the movements of the RSI indicator within a given period. It doesn’t emphasize current price levels. The most popular calculation period is 14 (days, sessions, hours or even minutes).

The resulting number is a figure between 0 and 1, swinging with a centerline of 0.5. Centerline crossovers are used primarily to confirm buy or sell signals. A move above 0.5 indicates a continuous buy signal, and a decline below 0.5 acts as a continuous sell signal. It’s essential to note that some StochRSI calculators multiply the output by 100, providing readings in the range of 0 to 100. In addition, another popular calculation duration for StochRSI is 20 periods.

As a trader, it’s critical to understand that StochRSI can be applied to any time frame for the identification of price movements or market trends.

How to Calculate Stochastic RSI

Stochastic RSI uses RSI as its base. The StochRSI formula is as follows:

Stochastic RSI = (Current RSI − Lowest RSI) / (Highest RSI − Lowest RSI)

As mentioned, traders can apply this formula for different trading periods, including days, hours or even minutes, and every trader should understand how to read the stochastic RSI before applying it to crypto trading.

What Does the Stochastic RSI Look 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 time period.

Below is a visual representation of the Stochastic RSI. 

Crypto traders using the 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 StochRSI in the coming sections.

Stochastic Oscillator vs. Stochastic RSI vs. Relative Strength Index (RSI)

These three technical indicators are used to analyze the price movements of assets, based on their strength and momentum. While they share fundamental similarities, there are some key differences.

• Base of measurement: The stochastic oscillator uses the closing price of a crypto asset as its base, whereas stochastic RSI uses the RSI as its base. Of note here is that stochastic RSI may lag more than stochastic oscillators, since it uses the RSI as its input, while RSI measures the magnitude of the recent gains and losses of an asset over a specified period to determine its condition.

• Measurement scale: The stochastic oscillator uses a value between 0 and 100 for tracking market momentum. The stochastic RSI, meanwhile, relies on a scale of 0 to 1, with 0.5 acting as its centerline. The RSI indicator oscillates between 0 and 100, taking into account average gain and loss over a chosen period.

• Number of signals: The stochastic RSI is more sensitive to market movements, and provides more information about overbought and oversold conditions as compared to stochastic oscillators. The RSI indicator uses fixed thresholds of 70 and 30, respectively, to signal overbought or oversold territory.

where n = the number of trading periods and K = the amount..

A visual example of these technical indicators are as follows: 

How to Use Stochastic RSI for Trading Signals

One of the primary uses of the stochastic RSI is to identify trading signals. Here’s how a trader can use this indicator to interpret the movements of a cryptocurrency.

• Buy signal: Any reading below 0.2 is in the oversold range, which means as the StochRSI moves above 0.2, the trader can consider it as a buy signal.

• Sell signal: If the reading crosses below 0.8, 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 strategies accordingly. 

Overbought/Oversold Signals

• Overbought signals:If the StochRSI of a cryptocurrency breaches the 0.8-mark and stays above this line, it’s in the oversold region. Traders seeking quick returns may want to close their positions. At the same time, traders can apply a shorting strategy if the value dips below 0.8.

• Oversold signals:When the StochRSI dips below 0.2, the cryptocurrency is in the oversold region. Prices are close to the lowest levels during the chosen time period, giving the right opportunity for buying (once it goes above 0.2).

The chart below visualizes the use of StochRSI on BTCUSDT price movement prediction:

StochRSI measures the value of RSI over the high/low range of a period. When the actual RSI indicator records a low reading below 40, the StochRSI will be close to 0, and vice versa: if the RSI's reading records a high, the StochRSI will be close to a reading of 100.

Stochastic RSI Trading Strategies

• Trading with StochRSI: One of the most common strategies is to trade between the levels of 0.2 and 0.8. For instance, in a (BTC/USDT) trading session with a low RSI of 25 and a high RSI of 60, with current levels at 50, the StochRSI comes out to 0.71. Since the StochRSI is close to the overbought position, it’s worthwhile to wait for the bullish correction and price reversal. If the reversal happens, the trader can open a short position near 0.5. The same strategy applies to a long call.

• Using StochRSI and divergence for identifying reversals: Since StochRSI is highly sensitive, it makes sense to use it with other technical indicators. The trader must pay attention to the divergence between the price of BTC and the StochRSI to spot a trend reversal.

Example: How to Use Stochastic RSI for Day Trading

Since the stochastic RSI allows traders to identify overbought or oversold conditions, it works as an excellent tool for identifying market momentum. The following is an example.

Identify and Trade the Short-Term Trends

By using this strategy, traders should pay attention to the centerline (0.5); any movement above 0.5 indicates an uptrend, whereas movement below 0.5 indicates a bearish trend. Traders can place buy triggers as the value goes above 0.5. Similarly, crypto traders can use a short-sell or sell as the oscillator moves below the 0.5 level.

Spot the Price Reversals

Crypto markets are notorious because of their volatility. Intraday trading in crypto requires a trader to identify any price reversals instantly in order to avoid significant losses. Traders can use the stochastic RSI to identify any such price reversals, and to open or close positions more effectively, due to its sensitivity to price movements. Traders are advised to use divergence and convergence as additional indicators when trading on price reversals.

For example, if the StochRSI moves above 0.80, it may imply that an asset is overbought, but it can also indicate a strong uptrend and remain above 0.80 for a prolonged period. On the contrary, if it falls below 0.2, it indicates the beginning of a strong downtrend. Any movement toward 1.0 could be considered a very strong uptrend, and any move toward 0 indicates a very weak trend.

Pros of Stochastic RSI

• More buy or sell signals: Stochastic RSI provides more buy or sell signals in comparison to the RSI indicator because of its higher sensitivity. It’s designed to predict extreme readings before the actual RSI reaches the extremities. If used correctly, crypto traders can identify multiple trading opportunities.

• Indicator of market momentum: For traders planning daily strategies, StochRSI can help identify momentum, thereby allowing traders to prepare an appropriate strategy.

• Identify short pullbacks and upward trends for scalping: The primary idea behind scalping is to benefit from short-term movements in the price of a cryptocurrency. StochRSI allows traders to spot short-term pullbacks, creating an ideal opportunity for scalping. However, it’s important to use it with other technical indicators in order to confirm the market momentum. A strong upward or downward trend may witness a breach of these established prices.

Limitations

• Distant from the real price of cryptocurrencies: Unlike the RSI indicator, which takes the price of a crypto asset as the base for its calculation, the stochastic RSI uses RSI as its base, putting it two levels away from the actual price of the cryptocurrency. It’s quite possible to witness a higher disconnect between prices and stochastic RSI readings. In addition, in some cases, traders may witness a slight lag.

• Higher volatility: The primary use of the stochastic RSI indicator is to find more buying or selling positions, which could be a shortcoming for new crypto traders. It’s advisable to use the stochastic RSI strategy in conjunction with other technical parameters, such as DMA and support-resistance indicators.

The Bottom Line

The stochastic RSI indicator has its benefits as well as limitations. Using the stochastic RSI in conjunction with other indicators can help traders create an effective trading strategy. However, it’s not advisable to use it as your sole indicator because of higher volatility of crypto and the distant relationship with current asset prices.

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