If you are a technical trader, you may have heard of two popular indicators: the relative strength index (RSI) and the stochastic oscillator. Both of these tools are used to measure the momentum of price movements and identify overbought and oversold conditions in the market. However, they have different formulas and applications that you should be aware of before using them in your trading strategy. In this article, we will compare and contrast the RSI and the stochastic oscillators and show you how they can help you make better trading decisions.
What is RSI?
RSI is an indicator developed by J. Welles Wilder Jr. that compares the recent gains and losses in a market to evaluate its strength or weakness. RSI is calculated by dividing the average gain of the up periods by the average loss of the down periods over a certain number of periods (usually 14). The result is then converted into an index that ranges from 0 to 100.
RSI is typically displayed as an oscillator (a line graph that moves between two extremes) along the bottom of a chart. The midpoint for the line is 50. When RSI moves above 70, it indicates that the market is overbought, meaning that the price has risen too much and may be due for a correction. When RSI moves below 30, it indicates that the market is oversold, meaning that the price has fallen too much and may be due for a bounce.
Traders use RSI to identify areas of support and resistance, spot divergences for possible reversals, and confirm the signals from other indicators. RSI is more suitable for trending markets, as it gives more weight to recent prices and reflects the strength of the prevailing trend.
What is Stochastic?
Stochastic is an indicator created by George Lane that compares the closing price of a security to its price range over a certain period of time. Stochastic is calculated by subtracting the lowest price of the period from the current closing price, dividing it by the difference between the highest and lowest prices of the period, and multiplying it by 100. The result is then smoothed by applying a simple moving average (usually 3 periods).
Stochastic values are also plotted in a range between 0 and 100. Overbought conditions exist when the oscillator is above 80, and oversold conditions exist when the oscillator is below 20. Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session (called %K), and one reflecting its three-day simple moving average (called %D). The intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum from one day to the next.
Stochastic also shows divergences between the oscillator and the price action, which can signal potential trend changes. Stochastic is more useful for sideways or choppy markets, as it takes all prices within its timeframe into account and shows how close the price is to its recent highs and lows.
How to Use RSI and Stochastic in Trading?
Both RSI and stochastic are used as overbought/oversold indicators, with high readings suggesting an overbought market and low readings indicating an oversold market. However, these readings are not enough to trigger a trade, as they can stay in extreme levels for a long time during strong trends. Therefore, traders should look for confirmation from other sources, such as price action, trend lines, support and resistance levels, chart patterns, or other indicators.
A common way to use RSI and stochastic in trading is to look for divergences between them and the price action. A divergence occurs when the price makes a new high or low, but the indicator fails to do so. This indicates a weakening of momentum and a possible reversal in direction.
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