Stochastic RSI in detail and how to use it.The Stoch RSI (Stochastic Relative Strength Index) is a technical analysis indicator used to identify overbought or oversold conditions in financial markets. It is a combination of two popular indicators: the Stochastic Oscillator and the Relative Strength Index (RSI). The Stoch RSI applies the Stochastic Oscillator formula to the RSI values, aiming to provide a more sensitive and faster signal for potential trend reversal.
The Stoch RSI is calculated as follows:
Choose the time period for which you want to calculate the Stoch RSI. The most common period is 14 .
Calculate the RSI: (Detailed post on this in the link below)
Determine the highest and lowest RSI values: Identify the highest and lowest RSI values over the same time period (e.g., 14 days).
Calculate the Stoch RSI: Use the following formula to calculate the Stoch RSI:
Stoch RSI = (Current RSI - Lowest RSI) / (Highest RSI - Lowest RSI)
The resulting Stoch RSI value will range from 0 to 1 (or 0% to 100%). A value above 0.8 (or 80%) typically indicates an overbought condition, suggesting a potential price correction or reversal, while a value below 0.2 (or 20%) indicates an oversold condition, which may represent a buying opportunity.
What does Stoch RSI tell us ?
Stoch RSI is a measure of how fast the RSI is changing. As an analogy. Imagine you are driving your car and have foot on the accelerator which will cause increase in the speed of your cat at every moment, now the rate at which your car's speed increases is acceleration. The bigger the more powerful engine your car has the more acceleration you get and the faster you get to the top speed of your car. So, in this analogy speed of your car at any instant is RSI , acceleration is Stoch RSI and top speed of your car is overbought condition of an asset.
RSI measures who is relatively more aggressive among buyers and sellers at a given instant. Stoch RSI measures how aggressive the buyers or sellers are at a given instant.
So just like in a fight if someone is too aggressive, they are going to spend themselves too quickly and even though they want to fight more they won't be able to until they ease up and relax a bit, this is similar to Stoch RSI of an asset getting to overbought condition and then asset either retraces or takes a pause as buyers are exhausted and need to regain strength by taking profits which turns them into sellers and the asset starts moving in opposite direction.
Why is 80 considered overbought?
The number 80 is chosen based on empirical evidence, suggesting that when the Stoch RSI reaches these extreme values, there is a higher probability of a price reversal or correction. When the Stoch RSI is above 80, it indicates that the asset's price has risen significantly over a short period and could be overextended. In this situation, the asset may be overvalued, and traders may consider selling or taking profits as the price could reverse or correct.
How to use Stoch RSI to enter a trade?
How to enter a Long Trade:
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Step 1. Always use Stoch RSI along with RSI to make a decision:
Step 2. Use it on mid to high term time frame (4h and higher).
Step 3. Make sure both RSI and Stoch RSI are in oversold zone.
Step 4. Make sure the asset is resting on a key support level and holding it.
Step 5. Fearlessly enter the trade.
How to enter a Short Trade:
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Step 1. Always use Stoch RSI along with RSI to make a decision:
Step 2. Use it on mid to high term time frame (4h and higher).
Step 3. Make sure both RSI and Stoch RSI are in overbought zone.
Step 4. Make sure the asset is rejected from a key resistance level and is not able to breach it.
Step 5. Fearlessly enter the trade.
What happens if Support or Resistance is broken in Step 3 above:
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That's where divergences come into play.
What is a divergence?
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Divergence is a technical analysis concept that occurs when the price of an asset and RSI/Stoch RSI indicator move in opposite directions, indicating a potential trend reversal.
There are two types of divergences: bullish divergence and bearish divergence.
Bullish divergence occurs when the price of an asset makes a new low while the RSI/Stoch RSI indicator makes a higher low. Remember from explanation provided in sections above, this suggests that even though the price is going lower there
are more buying activities than selling and the assets are becoming stronger, and a potential trend reversal may be imminent.
Bearish divergence, on the other hand, occurs when the price of an asset makes a new high while the RSI/Stoch RSI indicator makes a lower high.
I have highlighted bullish divergence in chart with purple line. Shown in Red line is bullish Divergence in Stoch RSI, when RSI is not fully oversold, this can happen when a new support is being formed on the chart due to changes in fundamentals of the underlying asset or some news events.
Bullish and Bearish Divergences are even more powerful signals for taking trades, but we must make sure price is holding a support or rejecting from a resistance before taking the trades, otherwise divergences can easily disappear.
Why do traders fail to effectively use RSI?
The primary reason is lack of experience in trading.
Which leads to impatient behavior.
Not knowing how to mark key support/resistance levels.
No risk management skills. (Taking too much risk)
Lack of trust in self when taking trades, (Keep stopping losses too tight which knocks them out of the trades).
I have shown several instances where RSI generated long signals and all of them were successful, the only reason a trader would not be able to use RSI effectively is because of the above reasons.
