Join us as we analyse how and when to use oscillators, with a specific focus on RSI (relative strength index) and stochastic oscillators. RSI and stochastic oscillators are some of the most popular oscillators and many traders use them incorrectly. We cover the differences between RSI and stochastic oscillators and review best practices on how and when to use them.
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Oscillators are a type of technical indicator that determines if an asset is overbought or oversold. Identifying trends is very important when trading and oscillators are used when a clear trend is not defined, along with other indicators such as moving averages. Therefore, if a market is experiencing a bull or market, oscillators may not be necessary. However, they are useful when a market is trading sideways or is particularly volatile with no clear trend.
Overbought and oversold levels are judged by trading volume. For example, if many investors are buying an asset, it will move towards overbought levels as the number of buyers slows down. This works in the same way for selling assets; an asset could enter an oversold situation if a large number of investors sell their stock and then slowly start to diminish over a specified time period.
Both the RSI and stochastic oscillators are popular price momentum oscillators that are popular amongst traders to forecast market trends. Both oscillators operate to determine if an asset is overbought or undersold but have varying methods to calculate their findings.
Both RSI and stochastic oscillators analyse overbought and oversold levels by measuring price momentum. A stochastic oscillator is based on the assumption that an assets current price will be closer to the highest price of its recent price range. In other words, stochastic oscillators use closing prices but also include the highs and low in a recent range. Whereas, an RSI would include just the closing prices of a recent trading period.
The RSI is the preferred tool by analysts, compared to the stochastic oscillator, but both are popular technical indicators that should be used in certain situations. As a general rule, the RSI indicator can prove more useful when markets are trending, while the stochastic indicator can be more insightful compared to the RSI in flat or choppy markets, where there is no clear trend.
The aim of both the RSI and stochastic indicators is similar, but they were designed differently and therefore, they have slightly different uses. As above, the RSI helps to distinguish when an asset’s price has moved too much, such as a market that has a trend, whereas stochastics are used to indicate when an asset’s price has reached the top or bottom of a trading range. As stochastics use closing prices, but also the top and bottom of a recent range, they are best suited for sideways markets with no clear bull or bear trend.
The RSI and stochastic oscillators are both momentum indicators that can be useful in different situations. They are, however, both types of oscillators that measure the acceleration of an assets price, indicating market entry and exit points based on overbought and oversold levels. However, an oscillator should not be used in solitary when to enter or exit a trade and is best used as a secondary indicator.
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