Custom Search

An article in the January 1990 S&C examined the use of a 14-bar stochastic on a monthly T-bond chart over a 12-year period. I was intrigued, so I charted the 14-bar stochastic on monthly data for both the Dow Jones Industrial Average (DJIA) and the OEX. Figure 1 shows the 14-bar stochastic for the DJIA and Figure 2 shows the same stochastic for the OEX. I then charted the 59-bar stochastic on weekly DJIA data, as there are about 59 weeks in 14 months. The weekly stochastic plot was more jagged, but the same times were identified by the extreme values. Moreover, the same time periods were identified by a 294-bar stochastic plotted on daily data (there are about 294 trading days in 14 months).

One logical conclusion stemming from these charts was that a long-term stochastic could help the investor or trader remain on the correct side of the market. A 294-bar stochastic slowed by 21 units crossed below the 80 level on Wednesday, October 14, before the severe market tumble on Black Monday, October 19, 1987! Figure 3 shows the daily OEX; the vertical marking connects the day of the stochastic crossover with the same day on the index.

How much shorter could the stochastic become before it no longer served as a useful trading tool? I experimented with various stochastic time periods, down to five. In comparing the charts, I realized that at certain times, many of the stochastics reached an extreme value simultaneously. That inspired me to overlay the stochastic plots.

Now, for more than a year, I have been overlaying multiple-length stochastic plots as a means of

identifying low-risk trading opportunities in the OEX and in stocks . These low-risk times occur when each of the stochastic plots are at an extreme value (above 80 or below 20), similar to the strategies that use extreme readings of the CCI and RSI plots.

I decided empirically to use four stochastics — 150/5, 50/5, 13/5 and 5/5 — more or less at random; there is nothing magical about these numbers. I did not optimize the parameters. These four sets of numbers represent the long term, intermediate term, short term and very short term, and the two components of each set represent the %K and %D values of the stochastic. To minimize clutter in the charts, I didn't plot the slowed %D (sometimes used as a trigger). All stochastics were plotted with simple moving averages rather than with exponential averages because simple averages calculate faster than exponential averages. Although calculation speed is not an issue when using MetaStock Professional, it did become an issue when I screened the database of stocks using another program. With MetaStock, using simple moving averages for the stochastic calculations meant using 150/5/1/s (the formula setup) as the conditions for

the long-term plot. I wrote several MetaStock macros to perform the charting procedure for two, three or four stochastic plots overlaid.

SOME SPECIFICS

Figure 4 shows the OEX and the three longest stochastic plots overlaid; the dashed line corresponds to the 13/5 stochastic, the dotted line represents the 50/5 stochastic and the solid line is the 150/5 stochastic. In general, when all three stochastic plots are above 80 or below 20, profitable trading opportunities exist. The best (most likely profitable) trade was to sell an index option. Sell a call when the three plots are above 80 and sell a put when the three plots are below 20; other traders might prefer to buy the opposite option. The trigger to open the trade is when the 13/5 stochastic crosses either the 80 or the 20 line.

Does this method work every time? No, because no indicator does. Does this catch every top or bottom? Of course not! Some trading opportunities will be lost, but it is better to make errors of omission rather than errors of commission. And using stochastic multiple lengths could increase my trading success rate.