Webster's defines stochastic as involving
or showing random behavior. A quick check of its Greek
roots shows that it comes from a word that means
"target" or "aim." Literally, "pointed stake."
The stochastics used to measure the
markets attempt to "put a stake in" at those points
where they are overbought or oversold. The random
behavior they attempt to measure is this: Markets in an
up trend tend to close closer to the high than the low,
and vice versa.
The two lines in any stochastic are both
moving averages. To calculate a stochastic, you must
first decide what the period will be. A period is
defined as the number of bars on any given chart used to
calculate the stochastic. In this strategy, we use a
period of 14, meaning we are using the last 14 bars to
calculate the stochastic.
Once we have our data set at 14 periods, the first
moving average is calculated. It is called %K. %K is
just a moving average of the 14-period data set. %D is
the next line in the stochastic, which is a "smoothed"
moving average of %K. In shorter terms, the %D is a
moving average of a moving average.
The stochastic oscillator available with
the eSignal application used in this strategy does a
comparison, based on a mathematical formula, that shows
where a security closed in relation to the price range
of that security over a specified period of time. The
three variables of the oscillator formula (as used in
the eSignal stochastic) are defined* as follows:
%K
Periods (Length, in eSignal) |
-- Number of time
periods of the stochastic calculation (In
eSignal, this is the first %K study property.) |
%K Slowing Periods
(Smoothing, in eSignal) |
-- The variable
that, depending on the value used, controls the
internal smoothing of %K (for example, 1 = a
fast stochastic; 3 = a slow stochastic) (In
eSignal, this is the second %K study property.) |
%D Periods (Length) |
-- Number of time
periods in a calculation of a moving average
(%D) of %K. (In eSignal, this is the third study
property, %D.) |
*As defined in *Technical Analysis from
A to Z* by Steven B. Achelis (New York: McGraw-Hill,
2001), p. 321
This strategy makes use of stops,
both protective (to help minimize your risk if the trend
reverses) and trailing (to help you keep any profit
you've made by lagging behind the day's prices; the
trailing stop also has a protective component). |