Stochastic Oscillator

Bull / Bear Dichotomy Indicator v 1.0 (BBD)

The purpose of a trading or investing model is to move probability in your favour. One can be considered worthwhile if it can consistently produce risk adjusted returns in excess of the broad market over any period greater than 2 years. A mechanical trading model can be considered worthwhile if in addition to this it can:

Remove emotion from decisions.
Do the hard work so you have the time freedom to enjoy your profits.

Regardless of the time domain of your preferred trading style, being able to clearly slice the market into high probability bullish and bearish periods is of great advantage. So far during the Technical Indicator Fight for Supremacy we have identified three very effective and different ways of doing this:

The True Golden Cross
Relative Strength Index
Stochastic Oscillator

Below I will cover a quick summary of the previous research or you can jump straight to the latest findings.

The True Golden Cross

EMA Crossover 13/48 EOD Long

Using a simple 13 / 48 Day EMA crossover; 62% of the time the 13 Day EMA was above the 48 Day EMA. During this time the average trade duration was 93 days and there was an annual return of 10.17% vs 6.32% for the global average during our test period. During the balance of time there was an annual return of -3.48% (see full tests and research).

Conclusion:

EMA(13) > EMA(48) = Bullish
EMA(13) < EMA(48) = Bearish

Relative Strength Index

126 Day RSI EOW, Long

Using a 126 Day RSI (with an EMA instead of Wilder’s Smoothing, it would be 63.5 instead of 126 on a standard RSI) and End OF Week (EOW) signals; 63% of the time the RSI was above 50. During this period the average trade duration was 97 days and there was an annual return of 8.73% vs 6.32% for the global average during our test period. During the balance of time there was an annual return of -2.77% (see full tests and research).

Conclusion:

RSI(126) > 50 = Bullish
RSI(126) < 50 =Bearish

Stochastic Oscillator

252 Day Stochastic Oscillator EOD, Long

Using a 252 Day Stochastic Oscillator (SO); 66% of the time the SO was above 50. During this period the average trade duration was 104 days and there was an annual return of 8.43% vs 6.32% for the global average during our test period. During the balance of time there was an annual return of -2.05% (see full tests and research).

Conclusion:

SO(252) > 50 = Bullish
SO(252) < 50 = Bearish

The Bull and Bear Dichotomy v 1.0 (BBD)

The EMA crossover shows us that there is value in measuring shorter term momentum vs longer term momentum. The RSI shows us that there is value in a measure of declines vs advances. While the Stochastic Oscillator shows us that there is value in being long a market when it is in the top half of its range. The trade profile for each indicator is desirable but their signals are often in conflict.

Don Beasley of Trademark Capital has been an inspiration of mine for many years and has been kind enough on several occasions to share his insight and experience. He likes to combine the RSI and Stochastic Oscillator by taking an average of the two. This is straight forward because both move between the same 0-100 range.

Including the EMA crossover is not as straight forward however; it is not limited to a scale at all. But because the percentage distance between the EMA(13) and EMA(48) should be normally distributed we decided to force it into a 0-100 range by using the cumulative distribution of a bell curve. It has a SD of 2.17% when EMA(13) > EMA(48) and SD of 2.35% when EMA(13) < EMA(48):

Bull / Bear Dichotomy v1 Example

Above you can see the readings from each indicator during a randomly selected 2.5 year period on the Australian All Ordinaries Index. The thick red line is an equally weighted average of the RSI, SO and MA Cross, smoothed with a EMA(10). This we are calling the Bull / Bear Dichotomy or BBD Indicator v1. By combining all three indicators, a greater level of stability and robustness is achieved. See below the full trade profile:

In looking at the trade profile the signal stability is clear with an average trade duration of 170 days, an average profit of 21.81% and a probability of profit sitting at 48%! The other statistics are not dissimilar to the component indicators. The only thing missing from the BBD is a measure of volume. We plan to include this in v2 and this will hopefully improve the stability further.

It is highly likely that that we are reaching the upper limits of what is possible, as far as returns, from a long term indicator applied to a blind selection of broad market indices. To improve on these results it will be necessary to do one or a combination of the following:

Have a selection process for the assets to be traded.
Apply a secondary trading system specifically designed to perform during the bullish or bearish environments identified by the BBD.

How do think these results could be improved? What other long term measures would be worth researching for inclusion in v2 of The Bull / Bear Dichotomy Indicator?

Please note: These returns are the result of evenly allocating funds between 16 different global test markets. If only one market was on a buy signal then only 1/16th of the capital was exposed to the market. Some markets performed better than others and lifted the returns. All were profitable and the strategy outperformed on an absolute basis on 15/16 of the test markets. A further explanation of the methodology can be found here.

Stochastic Oscillator (SO) – Test Results

The Stochastic Oscillator (SO) is a widely used momentum indicator. As part of the Technical Indicator Fight for Supremacy we have put it to the test through 16 different global markets~ (a total of 300 years data) to find out how well it works and what settings produce the best returns.

Download A FREE Spreadsheet With Data, Charts And Results

For all 1,248 Stochastic Oscillator Settings Tested

First of all lets establish how the market performs while the Stochastic Oscillator is in each 10th of its range:

Stochastic Oscillator Range 10

I have highlighted each of the negative results across a Red—>Orange gradient and positive results across a Light Green—>Dark Green gradient (depending on how great the loss or gain). Clearly most of the market gains occurred while the Stochastic Oscillator was above 50 and the lion’s share when it was above 90.

What this means is that when the market is in the top 50% of its range it has a tendency to go up and when it is in the top 90% of its range it has a strong tendency to go up. It also tells us that we want to avoid being long when the market is in the bottom 50% of its range. Over what period do we base this range? Interestingly, the returns do not change much over the different look back periods although the benefit of a longer look back is less volatility from the signals.

Lets now look at segments of 20-50% when the Stochastic Oscillator is above 50:

Stochastic Oscillator Range Above 50

The table above is colour coded Red—>Yellow—>Green from Lowest—>Middle—>Highest return. The message coming through loud and clear is that you need to be long when the market is making new highs if you want to make money. Over a 255 day look back (about 1 year) the difference between going long in the 50-90 range vs the 50-100 range is the difference between making 2.68% or 8.38% a year!!

Lets have a look at the trade profile:

252 Day Stochastic Oscillator EOD, 50-100 Range, Long, Any

The results above show what would have happened if a long position was opened and held any time, any of the 16 test markets had a reading above 50 on their Stochastic Oscillator (meaning that the market was in the top half of its range). We chose a period of 252 days, not because the returns were the best, but because this look back produced a longer average trade duration and 252 days is the average number of trading days in a year.

The returns are not as good as we have seen from other indicators such as the RSI or the Moving Average Crossover but they are still respectable. Furthermore an average trade duration of 104 days is advantageous when looking for a long term indication of market direction.

What about the %K signal line? We did test this but the results were not worth taking the time to publish. They are included in the results spreadsheet for free download if you wish to review them however.

Stochastic Oscillator Conclusion

The Stochastic Oscillator %K line is too volatile and is not worth considering in your trading as originally suggested by Dr. George Lane in the 50’s. There are better options for short term trading such as the FRAMA. In fact, there are also better options available for longer-term indications of market direction than the Stochastic Oscillator as presented in this article… So is it worth bothering with at all?

Well… YES and here is why:

The fact illustrated by these tests is that the majority of gains occur when the market is in the top 10% of its range and nearly all of the gains occur when the market is within the top half of its range.

There has been a lot or research published on momentum strategies and they typically involve buying the best performing assets out of a selection and then rotating funds periodically so as to constantly stay with the best. Many people fear holding markets that are near their highs so by rotating constantly into the current market leaders these fears are be alleviated.

What our tests on the Stochastic Oscillator reveal however is that simply holding an index fund when it is in the top half of its range (over almost any look back period) will capture the majority of the gains while STILL avoiding those much feared ‘bubble burst’ like declines. Contrary to popular belief; when a market bubble bursts it does not do so over night. Penny stocks my grow exponentially and then plummet the next day. On rare occasions large companies may even do so. But major economies can not turn on a dime.

“In the event of nuclear war, disregard this message.” – Warren Buffett

Therefore the Stochastic Oscillator could be a useful addition to a momentum rotation type strategy. Another idea worth considering is to change the rules for your trading system based to the Stochastic Oscillator reading. For instance we know that most gains occur when the market is making new highs, therefore the rules for taking profits on a long position should be different when the Stochastic Oscillator is above 90 than they are when it is between 50 and 60.

Both of these applications will be included in future tests.

More in this series:

We have conducted and continue to conduct extensive tests on a variety of technical indicators. See how they perform and which reveal themselves as the best in the Technical Indicator Fight for Supremacy.

~The data used for these tests is included in the results spreadsheet and more details about our methodology can be found here.
No interest was earned while in cash and no allowance has been made for transaction costs or slippage. Trades were tested using End Of Day (EOD) signals on Daily data.

Stochastic Oscillator (SO)

The Stochastic Oscillator (SO) (pronounced sto kas’tik) is a momentum indicator that was developed in the 1950’s by a group of futures traders in Chicago. Primarily attributed to Dr. George Lane (1921 – July 7, 2004) it is sometimes referred to as ‘Lane’s stochastics’. The term stochastic refers to the location of the current price in percentage terms relative to it’s range over a specific period.

“Stochastics measures the momentum of price. If you visualize a rocket going up in the air; before it can turn down, it must slow down. Momentum always changes direction before price.” – Dr. George Lane

Interpreting the Stochastic Oscillator

Because of Lane’s belief that momentum changes direction before price, he looked for bullish and bearish divergences as a warning of pending reversals.

Another method is to only take positions when the Stochastic Oscillator is within a specific range. e.g Only going long when the SO is above 80 (meaning a stock is with within the top 80% of its range over the specified period).

Active traders may choose to trade the SO directly from its signal line. e.g go long when the %K line rises above the %D line.

Below is a Slow Stochastic Oscillator with the most commonly used settings of N(14), %K(3) and %D(3):

Stochastic Oscillator

How to Calculate the Stochastic Oscillator

%K = 100 * ( Average(CL,s) / Average(HL,s) )

%D = User selected moving average of %K.

Were:

s = User Selected smoothing period.

CL = Close – Low(n)

HL = High(n) – Low(n)

n = User selected look back period for measuring the price percentage range.

Notes:

An ‘s’ of 1 will produce a ‘Fast Stochastic’ while a setting of 3 is typicality used for a ‘Slow Stochastic’. Interestingly the Williams %R is identical to the %K but mirrored at the 0% line.

Free Stochastic Oscillator Excel Download

We have built a free Excel Spreadsheet for you to download containing an SO that will automatically adjust to the settings you choose. You will find it at the following link under Technical Indicators.

Is the Stochastic Oscillator a good indicator?

As part of the Technical Indicator Fight for Supremacy we putting it to the test through 300 years of data across 16 different global markets – See the results.