The stochastic-RSI

Although currencies are noted (rightly or wrongly) for their trending properties, many traders including professionals — operate on short-term time frames in this market.

The relative strength index (RSI) is a popular oscillator traders typically use to identify shorter-term overbought and oversold conditions. As with most oscillators, the RSI is best suited for trading range markets such as shown.

While the indicator’s default look-back period (suggested by the indicator’s developer, Welles Wilder) is 14 bars, a nine-bar look-back is used here to make the RSI more sensitive to short-term price swings. The overbought zone is above 70 and the oversold zone is below 30.

The RSI peaks and troughs just before or as the market peaks and bottoms. The first peak occurs at point A as the RSI closes above 70 and the Euro/U.S. dollar pair (EUR/USD) hits 1.2400; price then moves into a short-term trading range before breaking down to below 1.2310. When the RSI drops below the oversold level of 30 (B), the market rallies half way back to its high, then reverses and retests 1.2310. At point C the RSI once again tags 30 and the market rallies again.

The market moves toward the 1.2400 level again, but falls short; the RSI moves above 70 and reverses (D) as price moves back down. During this retracement, the RSI doesn’t reach 30. The market moves above 1.2400, fails, and the RSI again reverses from the overbought level (E).

Although the RSI was fairly adept at reflecting the swings in sideways environment, the indicator (or any other oscillator, for that matter) can fail you when a sustained trend is underway.

The weak market causes the RSI to repeatedly indicate oversold conditions (points A, B, C, D, E, and F) when the market is trending down. The typical response to an oversold RSI is to buy, but in this case the oversold signals are setting you up to trade against the trend, which is not good. Also, the RSI peaks (points G, H, I, and J) never reach the overbought level, so the indicator fails to generate the desired sell signals that would allow you take advantage of the downtrend.

A solution to this problem is to apply the stochastic oscillator to the RSI. To better understand why, we will first look how oscillators behave in trading range markets vs. trending markets and show how the combined “stochastic-RSI” indicator combats the drawbacks these tools are subject to during trends.