OAP 042: This Stochastics Tweak Was The Difference Between Making Or Losing Money

stochastics indicator

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The Stochastics indicator has long been a favorite for investors and could arguably be one of the most popular technical analysis indicators.

Today I'm going to show you the results of our backtesting analysis on the Stochastics Indicator and I think you'll find it extremely useful wWhether you've used it before to trade or if this is your first time looking it up.

Now, unlike the results we saw in Show 41 of the podcast, today's mini-case study did see a positive correlation between win rate and overall net profitability of the indicator after making a small change to the way we generated signals.

As we've been trying to prove with case studies on the Simple Moving Average, Absolute Price Oscillator and today with Stochastics; there are clearly winners and losers that we found as part of our 20-year technical analysis research report.

About the Stochastics Indicator (STO)?

The Stochastic Indicator is based on the premise that if stock prices are increasing, then the closing prices tend to be near the upper end of the range. Conversely, in downtrends, the closing price tends to be near the lower end of the range. Therefore, the central purpose of this indicator is to assess where the current price is located in relation to the price range of the last few days. Though different variations of stochastics occur from fast to slow, for the purposes of our research report SIGNALS, we used the Full Stochastics.

Full Stochastics as we backtested is made up of three lines, always oscillating in a range from 0 to 100. The primary %K fast line  (14 day) shows the ratio of differences between current close and lowest price and between highest and lowest prices. The %D slow line is a simple moving average (3 day) of %K fast line's values. Finally, we add the %D smoothing line, which is a simple moving average (3 day) of %D slow line's values. This signal increases in reliability if the crossover occurs while the lines are in the oversold or the overbought territory.

Stochastics Indicator Example

As part of our research, we tested 2 major classes of signals with Stochastics. The first grouping was just purely based on the %K line crossing above or below the %D line. The second grouping also overlayed the requirement that this cross had to occur in pre-defined overbought or oversold zones. The first 20 of which are visible in the image below taken from page 42 of the Appendix. You'll notice that simply adding the overbought/oversold zone requirement to the backtest resulted in the win rate more than doubling over the testing period and the net overall profit turning positive on average.

Stochastics Indicator Backtesting Results

Again like we saw with some of the previous indicators we've revealed (including the Simple Moving Average and Absolute Price Oscillator) the Stochastics indicator still doesn't create the opportunity to make money long-term with its use.

Sure the win rate is high but long-term even the most optimal settings produced annual CAGR of around 1% per year which dramatically underperforms the benchmark SPY index over the 20-year period.

Pick up your copy of SIGNALS today and finally see which technical analysis indicators you should be using. If you have any questions at all please add them in the comment section below and I'll make sure to personally respond to each and every one of them this week.

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Real-Money, LIVE Trading:

  • IWM Iron Butterfly (Closing Trade): Exiting this IWM iron butterfly options trade gave us a $1,100+ profit after pinning the stock price one day before expiration at the peak of our spread.
  • CMG Iron Condor (Opening Trade): I just recorded my live trading platform (and real money account) as I walked through the process of entering a new iron condor trade in CMG stock. Inside you'll see me analyze, price and fill the trade in real-time.
  • APC Strangle (Closing Trade): Took about $150 out of this small APC strangle trade even after the stock moved completely against our short call strikes this month. But as always, implied volatility always trumps direction and because IV went down, the value of this spread dropped more-so than the impact of the directional move higher.
  • IYR Call Credit Spread (Adjusting Trade): This adjustment is good for 2 reasons. First, it reduces the overall risk in the trade if IYR continues to move higher. Second, it still leaves room for the stock to fall back down into our new profit window.
  • XHB Straddle (Closing Trade): We were able to bank a $120 profit early in the March expiration cycle for our XHB straddle with the stock trading right in the middle of our expected range.
  • AAPL Call Calendar (Opening Trade): Look behind the scenes as I use our new watchlist software to filter quickly and find this AAPL call calendar spread trade during overall low implied volatility in the market.
  • COF Strangle (Adjusting Trade): Here I recorded my live trading screen (and real money account) showing you the entire thought process we used to make an adjustment to my current short strangle in COF to reduce risk.
  • GDX Strangle (Opening Trade): With gold's high IV we are getting into a new strangle with a 70% chance of success and a decent credit for selling option premium.
  • IBB Iron Condor (Closing Trade): Today we're exiting an iron condor we traded in IBB for a $142 profit. Inside you'll see me analyze the exit price and fill the trade in real-time.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.