RSI and stochastic: measuring market momentum

Moving averages follow the direction of price. Oscillators measure something else: the speed and intensity of the move, known as momentum. The two most common are the RSI and the stochastic. They swing between 0 and 100 in a pane below the chart, and they are often misused because traders read them too literally.

The RSI: relative strength

The RSI (Relative Strength Index) compares the average gain with the average loss over a given number of candles, 14 by default. If recent bullish candles have been much bigger than bearish ones, the RSI climbs towards 100. In the opposite case, it falls towards 0. At 50, gains and losses are in balance.

Platforms calculate all this automatically, with a slightly more elaborate smoothing method. What matters is understanding what the number represents: a balance of power between rising and falling candles, not a price level.

The 70 and 30 levels

By convention, an RSI above 70 indicates an overbought market: it has risen a lot in a short time. Below 30, it is oversold. The trap is believing that an overbought market must fall. In reality, it mostly signals that buyers are very active. In a strong trend, the RSI can stay above 70 for days.

The stochastic: where the close sits

The stochastic asks a different question: where does the latest close sit within the range of the last N candles? If price closes right at the top of that range, it reads close to 100; right at the bottom, close to 0. It has two lines: %K, the main line, and %D, its three-period average. The standard setting is 14, 3, 3.

The usual stochastic thresholds are 80 and 20, wider than the RSI's because it moves much faster. A cross of %K below %D above 80, or above %D below 20, is the most widely followed signal.

Range or trend: two different uses

This is the point that makes all the difference. Oscillators are not read the same way depending on market structure, which you learned to identify in the lesson on trends.

• In a range: the extremes are meaningful. A stochastic crossing down above 80 while price touches the top of the range strengthens the case for selling towards the middle or bottom of the band.
• In an uptrend: ignore overbought signals. Wait instead for the RSI to drop back towards 40-50 during a pullback, then turn up: that is often the end of the correction.
• In a downtrend: same logic in reverse, an RSI that climbs back towards 50-60 then rolls over often signals the end of a bounce.
• Trend guide: in a healthy uptrend, the 14 RSI tends to stay above 40; in a downtrend, below 60.

As for settings, resist the urge to keep changing them. A 7 RSI reacts faster and hits the extremes more often, a 21 RSI is calmer and gives fewer signals. Neither is better in absolute terms. The defaults have one decisive advantage: they are what the vast majority of traders look at, so they are where collective reactions are most likely to happen. Keep 14 for the RSI and 14, 3, 3 for the stochastic until you have tested something else on solid historical data.

What to remember

The RSI and the stochastic are momentum thermometers. They help you spot a move running out of steam or a pullback coming to an end, but they never decide for you. Start with market structure, choose your zone, then look at the oscillator as one confirming element among others. In the lesson on divergences, you will see their most powerful use.