Ultimate Algorithmic Trading System

44
STOCHASTICS AND AVERAGES AND RSI! OH, MY!
becomes a three-period moving average of the slow %K. The two versions can be
confusing so most people simply use the slow variety. Through my obeservations
the fast stochastic seems to be very erratic.
The default parameters for the slow stochastic are (14, 3, 3) where the 14
represents the raw %K calculation period, the first 3 is the initial smoothing length,
and the second 3 is the secondary smoothing.
As you can see from the %K formula, the numerator will always be less than or
equal to the denominator and therefore produce a reading between 0 and 100. If the
close is near the lowest low, then the formula will produce a low stochastic.
Most traders utilize the stochastic (STO) as an overbought/oversold indicator with
80 and 20 as the corresponding thresholds. If the STO is high, then the momentum
is very bullish, and if it’s low—well, it’s pretty obvious. Just like the RSI, the
STO can be faked out into believing a market has become overbought/sold when in
fact the market is in a very strong trend. A unique feature of the STO (and some
other oscillators) is that it incorporates a trigger. Instead of simply buying/selling
in the oversold/overbought territory a trader can wait until the slow %K crosses
above/below the slow %D. Remember, these calculations are simple moving
averages of the raw %K and when a shorter-term average crosses the longer term,
this indicates a short-term shift in momentum.
Figure 2.8 shows trades where the slow %K crosses slow %D in overbought and
oversold territories.
Entry signals for a stochastic oscillator crossover algorithm can be defined by
simple if–then constructs. So a simple flowchart can be used to model this type of
trading algorithm. The flowchart is shown in Figure 2.9.
FIGURE 2.8
Source: TradeStation
Chart showing trade signals from stochastic crossover algorithm.
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