Introduction to the Stochastic Relative Strength Indicator
The Stoch RSI is a combination of the Stochastics oscillator and the Relative Strength Index. This indicator takes the RSI and increases its volatility. This sensitivity produces more signals by measuring the RSI’s momentum.
If the Stochastics oscillator is correct in the hypothesis that changes in momentum lead to changes in value over time, then the Stoch takes the RSI and makes it more “black and white”.
RSI VS Stoch RSI:
The Stoch RSI uses the Stochastics oscillator and applies it to the RSI, meaning that the RSI’s relative high and lows over a period of time are accentuated. This makes it a momentum indicator of a moment indicator that sits in a range between 0 to 100. This means that the RSI derivative is twice removed from price, making it two steps removed from the original variable calculated (price). This means that the main advantages are increased sensitivity and more signals. The major drawback of this indicator is that sometimes it can lag behind or have disconnects from real movements in price action.
As a general rule, it is viewed as an indicator that performs well when an asset moves sideways in a range. This means that momentum shifts and over-bought and -sold conditions are easier to identify. This is opposed to the RSI which performs better when an asset is trending up or down. Both of these indicators are viewed as fairly reliable when examining long- and short-term market trends. As always though, a good trading strategy is dependent on using several non-correlative indicators in conjunction with each other.
Since the RSI is a derivative of price and the Stoch RSI is a derivative of the derivative it stands to reason that these indicators would tell different stories, thus different assumptions. The Stoch RSI believes that prices will close near their all-time highs and all-time lows before returning to the mean. It also adds in two additional variables, previous highs and lows, to the equation. The Stoch RSI is also generally considered to be more useful when things are in-range rather than trending up or down while lagging behind because the calculations are two steps away from what you are measuring (price momentum).
So what does this mean for crypto? If crypto is going sideways, then the Stoch RSI is a “better” option. However if markets are trending up or down then it’s a “better” idea to use the RSI. This is because the more volatility, the greater potential for the Stoch RSI to produce false positives.
The calculation is simple. Apply the Stochastic oscillator formula to the relative strength index. Then use the values to determine whether something is overbought or oversold. In the most simple terms, the formula is as follows:
RS = Relative Strength = AvgU / AvgD
The average price goes up is determined by the time frame (1 day/1 week) and the time horizon (1 bar or 100 bars). The simplest way to calculate these averages is as follows:
N = number of bars
U = Up moves
AvgD = sum (ND)/N
Finally, calculate the Stoch RSI by doing the following:
min[RSI]=Lowest RSI reading / N (usually 14)
max[RSI]=Highest RSI reading / N (generally 14)
StochRSI = RSI−min[RSI] / max[RSI]−min[RSI]
0 = lowest point
100 = highest point
50 = mid-way
20 = oversold
80 = overbought
The RSI is a relatively simple indicator to use with two main strategies. Selling or buying at the extremes, or selling or buying at the middle mark. Both could be implemented in a trading system with multiple indicators. As we saw from the calculation section, technical analysis that ranges between zero and one and overbought/oversold values are 80 (“buy signal”) and 20 (“sell signal) respectively.
Since the Stoch RSI is volatile it generally has a moving average put onto it to smooth things out a little. The larger the moving average the more stable. Some values used are either 10 or 3. The longer the time frame, the greater the moving average that is used. This may help to reduce false positives as well. As mentioned before, because the Stoch RSI is a derivative of a derivative of price momentum, the indicator is sometimes out of sync with actual price movement which means that it lags slightly more then the RSI, which is something to take into account.
The other strategy is to buy or sell when the indicator hits the middle point (50). This would mean buying or selling depending on whether or not price momentum is going up or down. This is called an RSI crossover. In other words, once the indicator hits 50 there is more chances of price continuing on the same path. If the indicator moves over 50, then it’s a buy signal, if it moves under 50 it’s a sell signal. If prices move to a new high or a low without confirmation from the Stoch RSI this is indicative of a divergence which could mean a price reversal.
The Stoch RSI is an indicator that increases the volatility of the RSI to produce more buy and sell signals. This has the drawback of the indicator lagging slightly more than the RSI and producing more false positives. The major advantage to the Stoch RSI is that it works better when things are chopping sideways. This means that for cryptocurrencies, which are obviously very volatile, the RSI is the more useful indicator in this circumstance. Does this mean that the Stoch RSI is completely useless?
The answer is no. If a trader wants more buy and sell signals, then it’s a good way to have them. However they should practice their own due diligence and look at the historical price and see which Stoch RSI moving average works best for the particular crypto currency they are trading.