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How Do I Build a Profitable Strategy When Spotting a Stochastic RSI Pattern?

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The most common use of the Stochastic RSI (StochRSI) in the creation of trade strategy is to look for readings in the overbought and oversold ranges. However, the heightened volatility of the StochRSI warrants caution.

Key Takeaways

  • The Stochastic RSI is used to detect readings in the overbought and oversold ranges.
  • It moves between readings of 0 and 1 with the ideal range falling between 0.3 and 0.7.
  • A trader should wait to act until price action confirms the move.
  • StochRSI readings that remain in oversold or overbought territory for an extended period may signal a trend reversal.

How the StochRSI Works

The StochRSI fluctuates between 0 and 1. Readings below 0.2 are considered to be oversold and those above 0.8 reflect overbought conditions. Oversold readings in a large uptrend are considered bullish signals and overbought readings in a larger downtrend are considered bearish.

Using the StockRSI

Overbought readings in a downtrend should be seen as a warning of a potential move rather than as an entry signal. The StochRSI must move back below the centerline at 0.5 to confirm the continued bearish trend.

Conversely, the StochRSI must rise above 0.5 following oversold readings in a larger bullish trend. StochRSI readings that remain in oversold or overbought territory for an extended period may signal a trend reversal.

Trade entry should not be made following overbought or oversold readings until subsequent price action confirms the move.

An Example Using StochRSI

Assume a security has been experiencing a pronounced downtrend for several weeks. It's printing RSI readings between 18 and 60. The current session prints an RSI reading of 56.

This would not typically be considered an actionable RSI reading but the StochRSI calculation tells a different story. The StochRSI for this session is (56 - 18) / (60 - 18), or 0.9. Such a significant overbought signal in a larger downtrend is an indicator that price is likely to resume its fall after the bullish correction.

Enter a short position using market or limit orders, depending on your preference, when the StochRSI moves back below 0.5. The highest high of the bullish retrace serves as a convenient stop-loss. Bulls tried and failed to push the price beyond this point once already so a move above this level may signal an end to the bearish trend.

What Is the Three Black Crows Pattern?

The three black crows pattern is a bearish indicator that a positive trend is on the verge of reversing. It can be used in tandem with the StochRSI to warn of an imminent sell-off of a security by traders. It dates back to Japan. A rice trader, Munehisa Homma, developed it in the 18th century to assist in his business endeavors.

Who Created the StochRSI?

Trading system and money management experts Tushar Chande and Stanley Kroll introduced the concept of the StochRSI in their 1994 book, The New Technical Trader. They wanted to put a focus on oversold and overbought indicators and their uses in trading.

What Does It Mean When the Market Is Volatile?

Market volatility is evidenced when stock prices and market indexes move up and down in a given period. Volatility increases as the trends grow in size. Volatility can be a good sign or a bad sign depending on your inclinations as an investor. Tracking volatility can be profitable but using it as a guiding gauge can come with a good bit of risk without the additional use of other indicators.

The Bottom Line

The StochRSI generates so many signals, both good and bad, that it's advisable to seek corroborating evidence of trend continuation from additional indicators. Consistently strong volume and candlestick patterns, such as the falling three methods or the three black crows pattern, strengthen the StochRSI signal.

Article Sources
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