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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).
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