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

Trading stochastics in context

Rose-colored glasses

We are perennial optimists and generally only see those things that favor the result we wish to achieve. Many systems suffer from this. Advertisements always show us the "best case" and tend to gloss over the less sterling times. To be successful, we must apply an unbiased, rigorous test and then accept its results.

To do so, let us develop a simple signal system combining the philosophies of the first and second rules. We shall require both %D and %K to read less than 25 immediately prior to or at the point of crossing, and we shall buy when %K crosses above %D. We remain in the trade provided %K is greater than %D, but shall immediately exit on any failure. Conversely, we shall sell short if and only if %K and %D are both above 75 and %K crosses beneath %D, exiting upon a termination of that condition.

By using the 25/75 levels, we filter out all of the crossings that occur in the mid-range. This should help eliminate whipsaws. We could expand this filter to 20/80 or 15/85. Doing so might increase the win/loss ratio, but will reduce the number of trades. These levels easily can be tested by the individual trader and applied based upon personal risk/reward tolerance.

Now, we select a random commodity and test a randomly chosen period for enough times to have statistical significance — at least 30. It is essential for the fairness of the test that these variables be randomly chosen. We don’t want to fall into the trap of picking the commodity or period where we already know things will be rosy. Consequently, we randomly choose gold, 60-minute bars, starting Jan. 18, 2011. The test generates 55 trades.

Gold begins at $1,365.50 per ounce at the onset of our test and ends at $1,397.90 on Feb. 22, 2011. If a trader simply bought and held, a profit of $32.30 per ounce would have been realized. That is our benchmark for the test. However, because nobody is possessed of perfect trading ability, we shall deem achieving 75% of the ideal $32.30, or $24.22, to be a trading success. During our test period, gold trades in a range from $1,309.30 to $1,410.10 (see "Gold swings"). Given this $100 range, we have every reason to hope for success with the stochastic oscillator because such conditions generally provide lots of room for swing-type movement.

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