Article: Stochastic Parameters

I guess it depends on which book you read.  One says Stochastic is to be used in trending markets only, another says to use divergence only for calling tops and bottoms and a third will say it is totally useless.  All 3 are right and wrong at the same time.  Any indicator is useless unless you understand what it was designed to do and how it was designed to be used.

Stochastic was designed based upon cycles.  The static use of 14,3,3 for the Stochastic parameters will get you in trouble unless you are trading a 28 bar cycle.  Stochastic was designed to use the 1/2 cycle.  Divergence is a warning of an impending change.  You can get 2, 3, 4 or more divergent tops or bottoms.  There is no specific number given for the indicator.

You can back test the heck out of Stochastic and come up with the wrong answer because it is the current cycle width that determines the accuracy of the indicator.  Do you want to use regular or exponential moving averages?   That is what the 3,3 is:  the moving average and the moving average of the moving average.  The Moore report used to give the stochastic indicators for the various commodities and they changed every month, and they were different for up moves and down moves for the same commodity.  That is what they got by back testing. 

If you check the cycles, you will find that they are fairly constant for a specific commodity, stock or index.  Usually all the stocks in a sector will trade on the same cycle.  There are always the exceptions.  Cycles are always measured from low to low.  Never from high to high.  A low is defined as a bar that is lower then the previous bar and lower then the following bar.  Therefore, you can have a low in the middle of an up trending  or down trending move.   For a better understanding of cycles read Hurst's book.  It is about the best out, even though it is about 30 years old, and still pertinent.

Like any other indicator that I have found, it will not stand alone as a entry and exit tool for a trading system.  It can be used very advantageously in a trading system.  I use it in mine and find it very helpful.

Article by Ira Tunik