The following is a guest post from @PatternsWizard of PatternsWizard.com
What is the Relative Strength Index (RSI)?
RSI is a technical indicator used in technical analysis that helps to gauge the velocity of price changes. It is also a momentum oscillator and can point to overbought/oversold market conditions.
RSI functions on the assumption that prices tend to move far from the mean before reacting or retracting. Quick price increases and decreases lead to overbought and oversold market conditions.
The RSI values and the slope is directly proportional to the momentum and extent of price movements and are very helpful to identify overbought/oversold conditions.
- Welles Wilder developed the RSI oscillator and it works on a formula that takes past “n” periods into consideration. It derives its values by dividing the total positive fluctuations in a period by the total negative changes. That means RSI values get higher and higher whenever the magnitude of price fluctuations increases.
As a result of its construction, RSI values range between 0 to 100. Values above 75 indicate overbought conditions while values below 25 indicate oversold conditions. Relatively higher RSI values (55-75) alludes to a positive trend. Conversely, lower values (25-45) signify a negative trend.
What is the Stochastic RSI Oscillator?
The Stochastic RSI oscillator is a standard oscillator that is used in technical analysis. It is a range-bound oscillator and helps to find price momentum. The Stochastic RSI is quite good at determining overbought/oversold levels as well that signify falling or rising momentum.
George Lane originally developed it to compare the closing prices to a range of prices over a defined period of time. The Stochastic RSI plots values between 0 and 100. Values above 80 indicate overbought market conditions. Values below 20 indicate oversold market conditions.
The Stochastic RSI’s charts consist of two lines. One of them gives actual readings of the oscillator of a particular session. The other one gives the three-day simple moving average. Lane had the belief that prices show a natural tendency to close near their highs during uptrends and vice versa.
As prices are believed to follow momentum, the intersection between the Stochastic RSI’s two charting lines indicates a huge shift in momentum. That means the intersection also indicates the upcoming reversal of the current trend in the market.
What was the need to develop the Stochastic RSI version of RSI?
The basic reason was the inability of RSI to reach extreme levels of 100 and 0. RSI can oscillate between 80 and 20 for an extended period of time without reaching extreme levels. Traders are supposed to trade when RSI values indicate overbought/oversold market conditions. They are left clueless when the oscillator starts to move within the range. Welles developed the Stochastic version of RSI in order to overcome this issue. He wanted to make RSI more sensitive and generate more signals of overbought/oversold conditions.
Stochastic RSI vs RSI
Stochastic RSI and Relative Strength Index seem similar (especially because they have RSI in their names) but there are certain differences between the two oscillators. There are construction differences as well as use differences. The following are the key differences between the Stochastic RSI and RSI.
- Stochastic RSI works on the assumption that prices show a natural tendency to close near their highs during uptrends and vice versa. On the other hand, RSI functions on the assumption that prices tend to move far from a mean position before reacting or retracting.
- Stochastic RSI takes into consideration closing price plus highs and lows in a recent range to calculate values. Whereas, the RSI oscillator takes only the closing price of a recent period to calculate its values.
- Even though the goal of each oscillator is to identify overbought/oversold market conditions, they yield different results. The RSI helps technical traders to determine when a stock price moved too fast. On the other hand, Stochastic helps to determine when a price moved to the highest or lowest point of a trading range.
- The RSI oscillator performs really well in trending markets as it identifies fast-moving stock prices. The Stochastic RSI yields good results when the market is flat or choppy. That means Stochastic is a better performer in non-trending markets.
- The RSI oscillator is relatively faster than the Stochastic. The RSI moves extremely quickly between the overbought and oversold areas whereas Stochastic moves slowly. The reason is Stochastic being an indicator on an indicator. It is a derivative of RSI that means it depends on the RSI as well. Therefore, it lags significantly because it is two steps away from prices.
- The RSI oscillator was developed to gauge momentum and identify overbought/oversold conditions. Whereas, the Stochastic RSI version was developed to be more sensitive and generate more signals. That means the Stochastic RSI generates more signals and triggers more overbought/oversold conditions.
Stochastic RSI vs RSI: Which is better?
The differences between the two oscillators do not imply that one is better than the other. Those are just the construction and use differences. Stochastic RSI and RSI are both extremely popular oscillators. The reason for their popularity is their usefulness. Both of them are momentum oscillators and identify overbought/oversold market conditions. Both of them are good at measuring price momentum as well. However, both of the oscillators perform better in certain market conditions. As a general rule, RSI is a better performer in a trending market whereas Stochastic performs well during flat or choppy markets.
When traders should use Stochastic RSI and RSI?
As we have already discussed that both the oscillators have the same aims but they were developed differently and therefore, have slightly different uses. Stochastic RSI indicates when a price reaches the top or bottom of a trading range. It uses closing prices and also takes into account the top and bottom prices of the current trading range. That is the reason that the sideways market without any bear or bull trend suits the Stochastic RSI oscillator. On the other hand, the RSI indicates how far and how fast a price moves. That means trending markets with clear bear or bull trend suits the RSI. Traders should only know when to use Stochastic RSI and when to use the simple RSI oscillator.
For more from the Patterns Wizard you can follow him on Twitter @PatternsWizard or visit his website PatternsWizard.com.