In the world of trading, there are a number of different indicators that traders can use to make decisions. The two most popular ones are RSI and stochastic. RSI stands for Relative Strength Index and is a measure used to determine overbought/oversold stocks based on recent price activity.
Stochastic is a momentum indicator that calculates how much prices have changed from their previous close. Which one should you be using? That’s up to you!
Sure, there are a lot of variables to consider with this one, and I’ll be honest that an “it depends” is my response. However, let me walk you through this piece so you can see how many fascinating aspects there are when deciding whether or not to use each indicator.
I told you immediately that it depended because the choice between the two indicators is highly influenced by your strategy and type of instrument.
Both are indicators for mean-reverting methods, but they have been classified differently and will react to price changes in different ways.
It’s also self-evident that in certain cases, an RSI may be more beneficial than a Stochastic.
Technical indicators are both in the same oscillators family, so they’re represented by two lines that move from 0 to 100.
The relative strength index and the stochastic indicator are both used to spot oversold or overbought areas. They’re primary predictors since they seek to detect a shift in trend.
What makes one oscillator better than another?
The RSI will provide fewer trade signals than the Stochastic, since it is adjusted in the same manner.
Providing fewer signals makes the Relative Strength Index more secure but also difficult to use without changing its period.
This chart of Apple shows that when the Stochastic is red and overbought, it is a good time to sell. But when it is green and underbought, it’s a good time to buy.
In this situation, the Stochastic will stay in overbought for a long time as the market continues to rise. The RSI is also early but there are less false indications.
Let’s see how they behave with an ETF that is not as fast, like SPY. It is a fund that copies a US stock market index called S & P500.
The same thing is happening again. I would buy with the Stochastic and sell with the RSI.
You can try a strategy for trading your equity instruments. The Stochastic will always be able to buy better than the Relative Strength Index, and the RSI will still be able to sell better than a Stoch.
Is there a reason for this? Yes, and the explanation is easy: the RSI at the same time is slower than the Stochastic, therefore it responds more slowly to market changes.
The market usually rises slowly. The Relative Strength Index is less likely to get confused and will only signal when the market has really risen a lot.
This means that the RSI does not always guess when the market will go down. The RSI is more accurate than the Stochastic Oscillator because it reacts less strongly.
When the stock market crashes, the price movements will be faster and more intense. The RSI will never catch a fast price movement like the Stochastic, which is more responsive.
Relative Strength Index vs Stochastic, what is the most used indicator by traders?
The answer to this question, in my opinion, is straightforward, the RSI is by far the most used indicator for trading with mean-reverting strategies and for detecting trend changes.
I have seen many automatic trading systems that use the RSI both as a signal and as a filter, while it is not often to find the Stochastic.
It is objectively more famous thanks to its inventor Larry Connor‘s bibliographic success, with his world-famous RSI2 Connors strategy.
I believe too many algorithms monitor the Stochastic in some way because, as we have said, it is a widely used indicator.
I am not saying that the hedge fund uses our platform indicator to enter and exit the market; I say that everything used by traders and investors is monitored, and the RSI is certainly used by many traders.
Market traders use the RSI and not the Stochastic to understand what investors think and whether they might be willing to sell or buy.
It is mass psychology of the general public, and it is, therefore, essential to use indicators that are widely used for two reasons:
- in technical analysis, many times, some patterns are self-fulfilling because many people operate the same way on the market.
- even the institutions monitor those indicators, and it is easier for there to be liquidity at certain times.
These two concepts were much more true 10 years ago than today; now, few markets are so illiquid as to be influenced by a technical indicator.
Anyway, if I can choose between two technical indicators that behave similarly, I prefer the most famous and most used one; in this case, I would choose the RSI.
Why does it work in the stock markets?
Stock markets tend to have a bullish bias, meaning they go up most of the time. Have they always gone up? Will they go up forever? We can’t know, but until now, in the long run, they have always risen.
Therefore, the signal that interests us most is the purchase signal, which, as we have seen, is best selected from the Stochastic.
It is no coincidence that the RSI Larry Connors’ inventor also uses his indicator to buy in the US Stock’s market but setting it to 2 periods.
In this way, the Relative Strength Index becomes much faster and can catch those quick and intense movements that the stock market makes to the downside.
Choosing between Stochastic and RSI to trade Forex
What I have explained to you that US Stocks markets do not apply to Forex Market. There are two currencies in the forex market and the price changes when one currency is more strong than another.
There is no bullish stock market bias in the forex market, and the price movements are also totally different.
This is why at the beginning of the article, I told you “it depends”, because each market behaves differently.
See how on EurUsd the two indicators move in a totally different way compared to stock.
It becomes challenging to choose one or the other, yet they have the same settings as before.
Indeed, also in forex, the RSI continues to be less reactive than the Stochastic Oscillator, but the difference is less striking.
We look for confirmation on another instrument; we see the Canadian Dollar against the Dollar, UsdCad.
In UsdCad, you can see that the Stochastic false signals increase, and the RSI continues to be more reliable.
Therefore, we have seen that in the forex market, the characteristics of the two indicators continue to be roughly the same. The Stochastic is always more reactive and therefore errs more often than an RSI.
But does provide fewer false signals really mean being more reliable?
In the next paragraph, I will analyze this aspect better because it could be misleading.
Which indicator is the most reliable?
Many traders judge a technical indicator in this way, they look at a chart, and if they see that there are many false signals, they decide not to use that given indicator.
The technical indicator is a line; the important thing is the strategy that is built around it.
Look at a 2-period Relative Strength Index for a moment; how many false signals do you see? Would you ever use such a strategy?
If you need to quickly enter and exit your trades because your strategy is to stay in position for only 5 days, you would never dream of using a 14-period RSI.
You may not be able to use 14-period Stochastic either, but it would still be the best choice.
So there is no more reliable indicator per se; there is an indicator that can do for you at any given time, and what you need to know is that with the default settings, an RSI will always be less responsive than a Stochastic.
Change the period to make them similar
The RSI indicator and the Stochastic are less different than they seem. In this article, I don’t want to examine the formulas and the code. The graphical analysis will be enough to understand the concept well.
In the figure above, you can see the RSI and the Stochastic on a USDCAD chart daily; as we have seen, the Relative Strength Index is much less reactive than the Stochastic, but what happens if we change the periods of the indicators?
If a technical indicator has a period of 14, it means that it will look at the previous 14 candles to make its own calculations.
Let’s decrease the RSI period from 14 to 3 and leave the Stochastic period unchanged as a first attempt. We also change the values of the oversold and overbought areas of the RSI, bringing them to 20 and 80 as the Stochastic.
This is how a 3-period RSI versus a 14-period Stochastic compares; as you can see now, the signals are very similar. The RSI curve is much more confusing than the Stochastic one because the period used is very short, but we managed to make them very similar.
In this other graph, you can see what happens by extending the Stochastic period: the two indicators continue to be very different because that is the essential parameter to change.
If you want to make a Stochastic more similar to an RSI, you will have to modify the parameter relating to the smoothing length, which is set to 3 by default.
Here is what happens by taking the value of the smoothing length to 14, even leaving the period unchanged: the two indicators are similar again. In this case, the Stochastic is much less nervous, and the curve is even better able to identify the overbought and oversold phases.
Which indicator to choose as a filter
I personally don’t like looking for proper input timing using an oscillator. Identifying a trend change through the overbought or oversold phases can be a very frustrating and unprofitable activity, both using the RSI and the Stoch.
It would be better to use the overbought and oversold areas only as a filter for your strategy; I try to give you some ideas.
You could use an RSI or Stochastic to prevent your trading system from buying when the indicator is in an overbought phase or vice versa from selling when the market is oversold.
The input pattern could be anything, it could even be on another time frame, but a daily filter using an oscillator is always a good idea.
If you are looking for a market reversal, you can use the RSI or the Stochastic to start searching for an entry signal as soon as the price is in an overbought or oversold phase.
I would make a differentiation for this kind of use, assuming that a trading strategy to work cannot have too many limitations or rules.
If I decide to look for buy or sell signals only in the extreme phases of a 14-period RSI on a daily chart, I will risk not opening trades for months, sometimes years. It would not make much sense to use such a strategy, while on the contrary, if you were to use the Relative Strength Index only to inhibit trading in extreme phases, it would make sense.
With the same reasoning, so I will prefer to use a Stochastic as a filter to search for an entry pattern because this indicator stays longer in the extreme phases.
If we are building an automatic trading system, the best thing to do is carry out backtests over very long periods, preferring the results that do not lower the number of trades.
Ultimately, both operating in a discretionary manner and using an automatic trading system, I would not use both indicators, but I would choose the most suitable by varying the inputs.
When in doubt, as I have said several times, I would always prefer an RSI.
In summary, the best choice between the two indicators is certainly the RSI for several reasons.
The first is that the most used, and therefore, I prefer the indicator monitored by all financial operators.
Having only one parameter is more comfortable to manage even in an automatic system, and the backtests will take less time.
It is less reactive, which I always look for in an indicator, even when it is a trend reversal strategy.
Stochastic can be useful as a filter because it signals overbought and oversold levels that last longer than an RSI. This way, the system will have more time to find trading signals within these zones.
We have seen that indicators react very differently based on the type of market and how the stock market has characteristics that make overbought and oversold very different from each other.