The Stochastic Indicator: When it Works, When it Doesn’t & Why

Many traders use indicators to determine when to enter and exit trades. Most charting software includes dozens of different indicators that can be displayed on the charts. Popular indicators such as the Stochastic, and MACD, are frequently discussed when traders get together. I have listened to a number of these discussions; the interesting thing is that people typically explain why they use a particular indicator by citing a number of examples of when it has worked for them. When they do, another trader will typically say something like, ‘well it did not work for me, so I use the XYZ indicator which is much more reliable’. When I ask the second trader why his XYZ indicator is more reliable, the explanation usually involves a few more examples of good trades.  

Examples do not prove anything. It is possible to flip a coin and have it come up heads five times in a row. Few traders would observe this and then think that when you flip a coin it always comes up heads. Yet for some reason people will read an article about an indicator that shows four or five examples of good trades it produced, and then they will go and risk their money trading the technique. They typically trade the new technique until it produces several losses in a row, and then they start looking for another article, that describes a ‘better’ technique, and the process repeats itself in an endless search for a better trading system.

Trading should be data driven, not based on emotion, wishful thinking, or hot tips from TV hosts. To be data driven one needs to test and analyze trading tools and find out what really works, and when each tool should be used. Traders must understand which tool to use for a specific task, and have a clear understanding of how the tool works, and what can and cannot be done with it. Traders should extensively test several trading systems and, based on the results of that testing, they develop a toolbox of different trading techniques that have shown effective results. Trading then becomes a process of selecting the most appropriate tool(s) from the trading tool box for use in the current market conditions.

As an example of the data driven trading approach we will examine the Stochastic indicator using backtesting techniques. Backtesting does not guarantee future results, nothing does and trading involves risks that may not be suitable for some. Traders should not use these, or any techniques, without fully understanding and accepting the risks involved. The information in this article is for educational purposes only, traders should check with their registered investment advisor before using trading tools or techniques to determine if they may be suitable in their specific case.

The Stochastic indicator is a widely followed indicator; but like most things in trading, using it without an understanding of how and when it works can create problems. There are no magic indicators that work all the time. One of the tricks to trading is to learn if, and when, different tools provide an edge; and then either avoid them (if they do not provide an edge), or use them in the proper market environment (if they have been shown to provide an edge). Trading blindly based on some indicator will eventually get you into trouble. Successful traders trade based on a data driven approach and an understanding of how the market and trading patterns usually behave in a given situation.

The Basic Stochastic System

The Stochastic indicator relates the current stock price to the price range over the previous twenty one days. The range is the difference between the highest and lowest prices in the last twenty one days. The Stochastic indicator is expressed as a percentage, and plotted on a scale of one to a hundred. Traditional use of this indicator indicates a buy when the Stochastic moves from below twenty to above twenty, and a sell is indicated when the Stochastic moves from above eighty to below eighty. An example of the Stochastic indicator and its use is shown in the chart below, (Fig 1: BEBE).

Fig 1: BEBE

In late September the Stochastic moves below 80 indicating a sell signal and BEBE starts dropping in price. In late October the Stochastic moves up above 20 indicating a buy signal, after which BEBE begins a rapid price rise. The Stochastic moves below 80 five days later indicating a sell signal. The next buy signal comes in late November and is followed by a sell signal in late December and another buy signal in mid January. All of these trades which were triggered by the Stochastic indicator moving above twenty or below eighty would have been profitable. An inexperienced trader who saw five good examples like this in a magazine article might develop an interest in the Stochastic indicator. Examples are interesting, but they prove nothing. Traders need to understand much more about an indicator than just seeing a few examples of when it works. The question of course is, “how often does this work” and, “should I risk my money based on these signals?”

In many magazine articles and books, that is all you get, just some examples of it working and then some traders just go off and start risking their hard earned money based on a few carefully selected examples. Crazy. The question is not, “Can we find a few examples of when the Stochastic indicator works”? The question of course is, “how often does this work” and, “should I risk my money based on these signals?”

In order to answer this question I first looked at all the trades made during the calendar year 2008 using the following three rules:

• Only consider stocks for which the 21 day simple moving average of the volume is greater than 200,000.
• Buy at the open tomorrow if the Stochastic was below 20 yesterday and above 20 today.
• Hold for five days, then sell at the opening the following day.

If the movement of the Stochastic indicator from below 20 to above 20 indicates that the stock is beginning a run, then a reasonable check on this is to buy on this signal and see if the stock is up or down five days later. We can use back testing techniques to examine a large number of Stochastic buy signals in order to determine the effectiveness of this indicator.

An example trade using the rules shown above is illustrated in the chart below, (Fig 2: CF). The Stochastic signal for CF moved from below 20 to above 20 on 07/24/08, which is noted on the chart by the up arrows. The trading rules called for an entry at the open on the next day which resulted in buying CF near 140.99. CF was held for a total of five days and then sold the following day at the open, at a price near 165.14. Following the Stochastic trading rules resulted in a net profit of about twenty four dollars in five days.

Fig 2: CF

The chart also shows that CF made a Stochastic cross in late May that would have been profitable using these trading rules, a third profitable trade resulted from another Stochastic signal in early July. Three profitable trades in a two month period is interesting. However a few examples prove nothing, so I looked at every Stochastic signal that occurred in all the stocks in my data base during calendar year 2008. The results are summarized in the table below, (Table 1: Trades in 2008).

Table 1: Trades in 2008

The table shows that during 2008 there were more than twenty six thousand signals on stocks in the data base from the Stochastic indicator system noted above. That is more trades than anyone is likely to take, but the key information is that after seeing a Stochastic buy signal, only 41% of the trades were positive after five days. Trading a system that shows losing trades nearly sixty percent of the time and demonstrates an annualized loss more than double that for just buying and holding the SPX does not make much sense. Blindly using the Stochastic indicator may end up costing you money.