A Stochastic Trading Strategy

This document discusses a stochastic trading strategy. It defines stochastic as involving random behavior and attempts to measure when markets are overbought or oversold. It explains that the stochastic uses two moving averages, %K and %D, where %D is a smoothed moving average of %K. The strategy looks for when the stochastic is below 20 and waits for lower lows in the market before buying above the previous bar's high, using an initial protective stop at the previous bar's low and trailing stops as the position moves in your favor.

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A Stochastic Trading Strategy

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Michael Harnack

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A Stochastic Trading Strategy

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 -- Number of time periods of the stochastic calculation (In

eSignal) eSignal, this is the first %K study property.)
%K Slowing Periods -- The variable that, depending on the value used, controls the
(Smoothing, in eSignal) 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.)

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).