From the June 01, 2011 issue of Futures Magazine • Subscribe!

Trading stochastics in context

As traders, we continually search for the Philosopher’s Stone to help us unlock the secrets of the markets. Numerous technical tools have been developed, many of which claim to be the solution we all seek. But, do such tools actually stand up to rigorous analysis?

Traders often view things through green glasses. Sadly, Oz isn’t always made of emeralds. It’s important to shed those spectacles and subject our technical tools to the harsh realities of a statistical magnifying glass. Here, we present a method of doing just that in the context of identifying winning trades. As mentioned in prior articles, a winning trade is one with a positive expected value (see "Moving averages provide a simple solution," April 2011).

One popular trading tool is known as stochastics, or the stochastic oscillator, developed by George Lane in the late 1950s. According to Lane, it is a momentum indicator showing the location of the closing price relative to its high/low range over a fixed number of periods. Theoretically, because the oscillator is range bound, it is useful for identifying overbought and oversold levels. Lane developed the fast oscillator %D and %K and sought divergences. To reduce the choppiness of these, a slow stochastic oscillator was developed based upon a three-period simple moving average of Lane’s original indicators. Many traders swear by stochastics, but should they?

Application

The stochastics indicator is plotted on a scale from 1 to 100. If the result is 70%, then traders get a warning indication of overbought conditions. On the other hand, if the result is 30%, then traders get a warning indication of oversold conditions.

Three types of trading rules often are applied to the stochastic oscillator. First, a buy signal typically is generated by a value under a set level, say 10% or 20%; a sell for values above, say, 90% or 80%. Second, a cross of %K above %D is considered a buy, while a cross below is considered a sell. Third, price and indicator divergences (for example, a lower low in price occurring concurrently with a higher low in stochastics) are assumed to precede turning points in price. (For more in the discretionary interpretation of stochastics, as well as the formula for its calculation, see "Trading stocks with stochastics".)

The lone application of the first rule generally is disregarded in a systematic sense. Research has shown overbought readings are not necessarily bearish. Securities can become overbought and remain so during a strong uptrend. Closing levels that are consistently near the top of the range indicate sustained buying pressure. Similarly, oversold readings are not necessarily bullish. Securities also can become oversold while the stochastic oscillator remains less than 10 during a strong downtrend. Closing levels consistently near the bottom of the range indicate sustained selling pressure.

The second rule is extremely attractive to the eye. A trader looks at a chart and sees a strong uptrend took place and, sure enough, the stochastic oscillator gave a clear buy signal near the start of the move. %K moved from beneath %D, to cross over it just as the trade erupted. What the trader often overlooks is all the times that situation took place in the oscillator, but no profit followed. This is a typical mistake that novice traders frequently make.

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