RSI and stochastic indicators are technical indicators used commonly by day traders to understand what’s happening in the financial markets. They are often used to identify overbought or oversold securities, such as stocks. The two indicators produce different results, but which one is more useful? Let’s put RSI vs Stochastic indicators head-to-head.
- RSI and stochastics are technical analysis indicators used to measure overbought and oversold levels.
- While RSI and stochastic indicators have similar goals, the methods to calculate them are different, and each has its pros and cons.
Understanding the Relative Strength Index (RSI)
What is RSI?
The Relative Strength Index (RSI) is a technical indicator created by technical trader J. Welles Wilder and first published in his book New Concepts in Technical Trading Systems in 1978. He developed RSI by comparing recent gains to losses in a market. In this way, RSI is a momentum indicator that measures the magnitude of recent price changes to determine oversold (too weak) or overbought (too strong) conditions in the price of a stock or other assets.
In other words, the relative strength index measures how strong a security’s recent performance has been compared to its historical performance. RSI is based on the premise that when prices move too far in one direction, they are likely to correct themselves in the opposite direction. When used correctly, RSI can help traders enter and exit positions during favorable times, maximizing profits while minimizing losses.
How is the RSI Calculated?
The RSI gets computed using the following formula:
RSI = 100 – [100 / (1 + U/D)]
- RSI = Relative Strength
- 100 = An arbitrary number that can get increased to make the indicator more sensitive or decreased to make it less sensitive
- U = Average of upward price closes (EMA of gains)
- D = Average of downward price closes (EMA of losses)
The indicator oscillates between 0 and 100. Traditionally, a value above 70 indicates that a security is becoming overbought or overvalued and may lead to a trend reversal or corrective pullback in price. A value below 30 indicates that it is becoming oversold or undervalued, while values between 30 and 70 indicate neutral market conditions.
The RSI is based on the difference between the average of the closing price on green days versus red days. Traders often use a timeframe of 14 days, but the RSI can get applied to any timeframe, from intraday trading to long-term investing.
The higher your average gain, the higher the RSI. When the average gains are greater than the average losses, the RSI goes up. You can see this in the charts when the size of the bullish candles is larger than the bearish ones. On the other hand, when the average gains are smaller than the average losses, the RSI goes down. You can see this in the charts when the size of the bearish candles is larger than the bullish ones.
Benefits of RSIs
There are many benefits of using RSI as part of your trading strategy:
- RSI can help you identify potential buying and selling opportunities. When prices reach extreme levels (either too high or low), it is often a sign that a reversal may be imminent.
- By tracking RSI along with other indicators such as moving averages or Bollinger Bands®, you can get a more complete picture of market trends and momentum. That can help you make more informed trading decisions overall.
- Because RSI is based on historical price data, it can get used to generate buy and sell signals even when there is no news or fundamental catalyst driving price action.
- RSI can help you stay disciplined with your trading strategy. For example, if you are long on a stock and the RSI moves above 70%, you may want to consider taking profits or cutting losses short. Conversely, if you are short on a stock and the RSI moves below 30%, you may want to consider covering your position.
Understanding Stochastic Oscillators
What are Stochastic Oscillators?
Created by technical analyst and educator George Lane, stochastic oscillators are momentum indicators that compare the latest closing price to the range of prices over a certain period. Lane believed that prices typically close near their highs when the markets are trending up and near their lows when the markets are trending down.
There are many different types of stochastic oscillators, but all share the same basic characteristics. They use a combo of historical price data and mathematical formulas to calculate momentum and rate-of-change values. These values can then get used to identify potential buy or sell signals in the market.
Stochastic oscillator charting often consists of two lines:
- One reflecting the value of the oscillator for each session
- One reflecting its three-day simple moving average
When these two lines intersect, it is considered a signal that a reversal may happen soon since it indicates a significant shift in momentum from one trading day to the next.
Stochastic oscillators can be helpful for traders looking for confirmation that a particular trade is worth taking. When combined with other indicators, they can provide a better picture of what is happening in the market at any given time.
Benefits of Stochastic Oscillators
There are many benefits of using stochastic oscillators as part of your trading strategy:
- Stochastic oscillators can help you avoid getting caught in a trend reversal. For example, if you are long in a stock that is starting to reverse direction, using a stochastic oscillator can help you get out before things turn ugly. In addition, it can be used to time your entries and exits so that you maximize your profits while minimizing your losses.
- Stochastic oscillators provide clear buy and sell signals, which factors price and momentum changes into account. That means that you do not have to guess whether or not the market has turned bullish or bearish – the stochastic oscillator will tell you.
- This tool works on all timeframes, so no matter what trading strategy you use, there is likely a stochastic oscillator strategy that works for you.
RSI vs Stochastic – What’s the Difference?
RSI measures the magnitude of recent price changes to determine if a security is becoming overbought (too strong) or oversold (too weak). Stochastic oscillators measure the location of the current closing price relative to its high-low range over a given timeframe. It produces a number between 0% and 100%, where readings below 20% indicate an oversold security and readings above 80% indicate an overheated security.
Both indicators have their pros and cons, but overall, RSI gets more commonly used because it gives traders a clear signal when there is an opportunity to buy or sell. For example, RSI can help you determine when a stock has been beaten down too much and may be due for a bounce, whereas stochastic may not provide as clear of an indication. However, stochastic can be more useful for identifying trend reversals than RSIs.
- The stochastic oscillator will give you more buy and sell signals, but it will also give you more fake signals.
- The RSI will give you fewer buy and sell signals, but it will also give you fewer fake signals.
Which is Better?
The stochastic oscillator and relative strength index are both popular technical analysis indicators used to measure the momentum of a security. There is no definitive answer as to which tool is better, as each has its strengths and weaknesses.
The stochastic oscillator can be more volatile than the relative strength index, making it less reliable for identifying overbought or oversold conditions. However, it can be more sensitive to changes in price and provide earlier warning signals than the relative strength index. The relative strength index tends to be less volatile than the stochastic oscillator and may give later warning signals, but it may also lag behind changes in price. Ultimately, which indicator you use depends on your personal preference and what setup works best for you.
The Bottom Line
Both the relative strength index and stochastic oscillator are price momentum indicators used to forecast market trends. While they have similar objectives, the two tools have differences in their underlying theories and methods.
The RSI measures the rate of change of the price of a security at a particular timeframe, while the stochastic oscillator measures the relationship of the current market price to the average price for a given timeframe. The RSI tracks oversold and overbought securities by measuring price movements, while the stochastic oscillator assumes closing prices should generally close near the same direction as the current market trend.
Both are well-known technical indicators, though analysts typically use the RSI more. Generally, the RSI is a more helpful indicator during trending markets, and stochastic oscillators are more useful during sideways or choppy markets.
Frequently Asked Questions (FAQs)
Is RSI or stochastic better?
There is no definitive answer to this question, as both RSI and stochastic can be effective trading indicators. One key difference between RSI and stochastic is that RSI gives more weight to recent prices, while stochastic takes all prices within its timeframe into account. That means that RSI may be more sensitive to short-term price changes, while stochastic may be more sensitive to long-term price changes.
Another difference is that RSI tends to trend upwards when prices are rising (indicating an uptrend), while stochastic tends to trend downwards when prices are falling (indicating a downtrend). However, these trends can vary depending on the security getting traded, so it is crucial to do your research before using either indicator.
Can I use stochastic and RSI together?
It is possible to use stochastic and RSI together to improve the accuracy of your trading signals. Stochastic can help you determine when a stock is oversold or overbought, while RSI can help you confirm whether or not this is the case. When used together, these two indicators can give you more accurate buy and sell signals, which can lead to increased profits in your trading portfolio.
Which is better – MACD or RSI?
MACD and RSI are both popular technical indicators used in the stock market. There are pros and cons to using each of these indicators. MACD can give false signals, while RSI can lag price movements. However, MACD is more sensitive to changes in trends than RSI, making it a better indicator for identifying trend reversals.