Table Of ContentStocks & Commodities V. 12:12 (501-506): Trading Markets With Stochastics by Louis M. Lupo
Trading Markets With Stochastics
by Louis M. Lupo
There are many systems for trading these days, some of them good, some not. Here's a reliable pattern
for trading markets using stochastic.
O
f the computerized trading systems and discretionary systems I have traded and developed, some
needed refinement, some needed reworking, and some were simply cannonfodder. However, one system
that has continued to perform in every hostile trading environment imaginable is the stochastic pattern
recognition system. Let me briefly discuss the theory behind the system and describe the parameters of
one particularly reliable stochastic pattern. I will then apply the parameters in a simple mechanical
fashion.
STOCHASTIC PATTERN RECOGNITION THEORY
By its very design, the stochastic is a momentum indicator. All stochastics referred to here will be a
14-bar close, slow stochastic with a three-bar smoothing. The stochastic, as opposed to other momentum
oscillators, measures the location of the most recent market price in relation to the highest and lowest
prices within the last 14 bars, not the price 14 bars earlier.
Although many traders and technicians use stochastics primarily for divergence and momentum analysis,
the stochastic oscillator can be used in a far more versatile fashion. Here, the idea is based on the premise
that certain price behaviors directly influence market momentum, leaving a distinct signature upon the
stochastic.
More specifically, all prices contain some price patterns with forecast reliability; all price patterns contain
market momentum information. Thus, market momentum, as revealed by some stochastic patterns, has
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forecast reliability. Just as bar charts reveal price patterns that are named and classified based on their
shape, frequency and forecast reliability, so do momentum charts, which show stochastic patterns with
shape, frequency and forecast reliability.
PATTERN PARAMETERS
The stochastic pattern I trade is one of the strongest and most reliable of the price forecasting patterns. Its
strength lies in its ability to sell at the top of intermediate bull market rallies or bear market corrections.
The trade signal will usually be in the direction of the long-term trend, but always against the direction of
the uptrend, as measured by a trendline and a simple 40-day moving average. Take a look at Figure 1,
which is an image of the Treasury bond, marked with the parameter numbers for the pattern, as can be
seen following:
1 The market will be in an established uptrend as defined by a trendline and the 40-period moving
average. This trading system requires many trend-followers — trendlemmings, if you will — using
systems that are always long at market tops and short at market bottoms. These market participants
must be well-established in their positions to provide the mass exodus of selling that marks an
intermediate-term top in prices.
2 The %K stochastic (the fastest stochastic line, represented by the dashed line) in an uptrend should
climb above the 70 to 75 area for at least three bars — for example, for the daily, it will be three
days, and for the weekly, it will be three weeks.
3A The %K stochastic should then fall below or to the 75 area, but not below 55.
3B During an extended trend with extreme stochastic %K readings of 85 or more, the %K stochastic
need only fall 10 to 15 points from the stochastic high.
4A The stochastic must then climb back into the 70 to 75 area within the next five trading bars. This
will give the stochastic the potential for the look of the second peak.
4B During an extended trend with extreme stochastic %K readings of 85 or more, the stochastic needs
to climb and retrace a minimum of 50% of its original fall from the first peak. This will also give
the stochastic the potential for the look of the second peak.
5 To remove the subjectivity from the stochastic pattern recognition system, a time frame of 10 bars
from the first significant stochastic momentum deterioration is then used to time the trade and
anticipate the market reversal.
More specifically, all prices contain some price patterns with
forecast reliability; all price patterns contain market momentum
information. Thus, market momentum, as revealed, has forecast
reliability.
Beginning with the highest price established while the stochastic was still in the uptrend, find the nearest
price bar responsible for causing the %K stochastic to move lower from the first peak. How much lower
is not as significant as is the loss of short-term momentum. This price bar will be the first bar of a 10-bar
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count.
6A A short position will then be taken on the close of the 10th bar. This position anticipates the top of
the stochastic second peak. This position may or may not have divergence confirmation. To keep
things simple, use the highest price of the 10-bar time frame as the stop-loss exit unless the 10th
bar is the high.
6B If the 10th bar is the high, then the short position will be entered on the very first sign of market
weakness within three bars from the 10th bar. This means that a position will be taken on the first
lower open or lower close of any of the next three bars. The reliability of the pattern diminishes
significantly if more than three bars are added from the 10th.
APPLYING THE PARAMETERS
In Figure 1, the market is in an intermediate-term uptrend during the October to February period.
Parameter 1 is thus met. The stochastic in late December and early January stayed above 75 for more than
three periods, so parameter 2 is met. Then, in the third week of January, the market action closed lower,
turning the momentum of the market down and forcing the stochastic below 75. Thus, parameter 3A is
met. The bond market rallied strong enough from 98 to 102 to push the stochastic back into the 75 area
again, and so parameter 4A is satisfied. With the first four parameters satisfied, it was time to seriously
consider the pattern as a possible market resolution.
Finding the bar responsible for turning the stochastic down is easy. Sometimes this price bar will be an
obvious negative close, while at other times it will be a trading period of stalling momentum. On Figure 1
the third week of January marked the first sign of stochastic deterioration, and so parameter 5 is met.
From here, it was simple to count from the third week of January to target the last week of March as the
10th week for a possible pattern. Thus, on the close of the 10th week, parameter 6A is met. I entered a
slightly aggressive short position in the June bond at 102, even though my soup of technical indicators
was in a neutral position.
After the close of the 11th week, the first week of April, the pattern was confirmed. By the end of the
12th week, a clear trend change as well as a wonderfully profitable short position in the bonds had
occurred. The pattern was now indelibly etched on the charts. The bearish divergence on this chart did
not occur until a week after the position was established; placing a money management stop in the market
with the after-the-fact technical indicators would have been unwieldy and expensive, limiting a
potentially aggressive position and profit potential.
In Figure 2, the daily March 1989 Value Line contract, the stochastics pattern bears a striking
resemblance to that of the Treasury bond in Figure 1. A divergence was also signaled on October 24 after
the stochastic pattern was traded, in this example a day later. Again, the parameters, especially 6A,
enabled me to take a much more aggressive position at 250.50. My stop-loss was only $600 away per
contract at 251.70 versus the divergence signal of $1,500 per contract at an entry price of 248.70.
The accuracy of parameter 6A is also displayed in Figure 3 (March 1989 soybean oil), Figure 4 (March
1989 coffee) and Figure 5 (December 1991 Deutschemark). The short positions established on the close
of the 10th bar were pain-free trades with a very tight, well-defined stop-loss. Figure 6 (October 1993
sugar) illustrates the valuable flexibility of parameter 6B. May 14, the 10th day of the pattern, was a new
high for the 10-day range. Since the market lacked any signs of weakness, the elastic three-day window
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was open.
At that point, most of the breakout buyers were lured into the market, if not on the close of the 10th day,
then certainly by the 11th day. As Figure 6 illustrates, May 17, the 12th day, was a technically devastating
lower close. Using parameter 6B, a position was entered automatically on this lower close at 1261, less
than $300 away from contract highs. The position was comfortably supported by other confirmation
signals. On the 11th day, the trend-followers (or trendlemmings) created an exhaustion gap.
Figure 7 (March Canadian dollar 1994) is a far less intimidating scenario compared with the October
1993 sugar market example in Figure 6, but it is another example of the value of parameter 6B of the
pattern. The 10th day marked the absolute high for the bear market rally. Therefore, a position was
automatically entered on the lower opening of November 8 at 7701. The 11th day provided a
minimal-risk entry with the stop-loss exit of the 10-bar high only $245 away per contract. Once again,
following the after-the-fact divergence confirmation signal would force a trader to enter at an inferior
price and provide generous room for a reasonable stop-loss, as much as $1,000 per contract.
TIME FILTERING
The parameters given thus far have been rigid and well-defined to keep things simple. This does not
mean that the parameters are inflexible. Experimenting with time filtering, for example, is always an
interesting, if not necessarily rewarding, endeavor. Time filtering uses similar systems to locate similar
signals within different time frames. Once located, these similar signals attractively increase the
probability of trading success.
In general, weekly charts are almost always more important than the daily charts because the weekly
charts are composed of greater time and trend duration and, therefore, much larger price moves.
However, daily price action takes on greater significance than the weekly when the daily price action has
the potential to create a high reliability pattern. A congruence between the weekly chart and such a
significant daily chart relays a strong trading signal.
Consider the pattern on Figures 8 and 9, which depict the weekly and daily charts, respectively, of the
March 1994 cocoa contract. Both focus on the same time frame with similar results. Examine the daily
price chart during the November 16th through December 6th time frame. The market was continually
unable to follow through after a new high for the range was established; each successive new high was
followed by a setback, and each setback looked as though the market had consumed too many buyers the
previous day and was sitting back to digest them. If this type of market action were to continue, the
weekly stochastic had a very high probability of showing the formation. The weekly stochastic paused in
the overbought area above 75, vulnerable to rolling over. Thus, a correction on the daily chart would
create an ominous formation on the weekly chart.
The daily stochastics gave the sell signal on December 6, five days before the weekly signal took shape.
Therefore, a short position was established on the 10th bar of the daily pattern. This position anticipated
that the 10th bar of the weekly pattern would probably confirm the daily pattern by not trading out of the
highs contained in the 10 bars of the daily range.
PATTERN FAILURE
Figure 10, the Standard & Poor's 500 December 1994 contract, illustrates a failed pattern. Consider the
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selloff period in Figure 10 during the July 30th to August 9th time frame. Instead of plunging, the
stochastic sank, resembling a camel in quicksand — a muddled and congested technical sight. But market
momentum and prices began to rise again within a few days. The pattern failed, even though the
short-term selloff did occur on the anticipated second peak of the 10-day cycle.
The resolution for completion of the pattern had to be immediate — at worst within 10 trading periods.
As can be seen from the other examples, if the pattern does not develop quickly after the position is
established, the likelihood of a false signal increases greatly. All of the successful examples display
market resolution that is powerful and decisive.
A typical sign of pattern failure will be a stochastic upswing crossover after the stochastics have already
turned down, as revealed by Figure 10. In addition, if the market begins to trade in a range and is slow to
impair technical support such as trendlines, moving averages and relative strength index (RSI) support,
the pattern is very likely to be a failure.
Because the stochastic pattern recognition system trades near price extremes, the wisest course at this
point is to liquidate the position before the market hits a new high. Taking the other course of placing a
stop-loss exit at the new market highs would entail a kind of casino risk with only a bingo reward. There
are two reasons for this. First, whenever you are able to sell a market near contract highs and stay with
the position for several trading periods, the chances are good that other traders are also pointing to the
obvious top in prices. A top in prices rarely gives the timid a second chance to participate or liquidate.
Now the second reason: With so many traders looking for a top and prices beginning to churn higher, the
adage of what is obvious to most is obviously wrong suddenly becomes very apropos. The old high in the
market suddenly acts like a powerful trading vacuum. If prices trade through the resistance at the old
market highs, the slippage suffered by stop-loss orders can be very substantial. I have found that it is
usually more profitable to pivot to a long position when the market threatens to retest highs from the
pattern. However, pivoting from signal failure is beyond the scope of this article.
BENEFITS
These few examples should evince the following benefits of applying the stochastic pattern recognition
system:
1 Even if price patterns or other indicators hold little clue to market direction, the stochastic can be
analyzed for possible trend reversal direction.
2 The system's well-defined periods limit false signals and subjectivity.
3 The system anticipates market tops rather than following trend-followers, who often call on
divergence long after a market has made a significant downswing.
4 Finally, and most important, the stochastic pattern recognition system enables the trader to define
risk clearly — the essence of sound money management principles. Thus, taking an aggressive
position is both attractive and responsible.
This is critical because every system is dependent on how well the system enables the trader to manage
the risk/reward ratio: the ultimate pursuit of system development and trade technique. What good is a
trade signal if the most reasonable stop-loss exit is, say, $2,000 away? The idea is to get as close to the
danger point as possible.
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CONCLUSION
Most of these trades have been at market extremes. At price extremes, the market almost always looks
indomitable. Although these trades look simple after the fact — the way trading should — remember that
it is psychologically and emotionally difficult with any system to obey even a mechanical signal at a
market extreme. This is especially true when most of your signals are strength-oriented and
trend-following in nature.
Sometimes fear can cause the trader to freeze on the trigger. To take some of this ugly emotion out of
trading, I would not only establish mechanical, and militantly disciplined, trading controls — worst-case
scenarios do happen — I would also practice looking at the market extreme of an old top and visualizing
the market top as though I were about to take a short position.
For example, I would mask the resolution of the market selloff with something opaque so I could
visualize as many market scenarios as possible, especially all the terrible things that could conceivably
happen to my trade. Imagining your position at market extremes will help give you the needed
perspective and the necessary practice for when the time does come to act.
Finally, when picking market tops and bottoms, use the smallest position possible or, better yet, engage
the options markets. This will give you time to consider what to do next. Let a little bit of money
management go a long way.
Louis M. Lupo, the head of Lupo Development Corp., is a veteran trader with a decade of futures trading
experience. His credits include managing money for several of the largest commodity trading advisors,
several in-house trader development programs and large commercial banks.
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FIGURE 1: WEEKLY T-BOND CONTINUATION CONTRACT. In each of the following charts, the
pattern parameters are identified. This chart includes the 40-period moving average, while the other
charts do not. During late March, the final parameters were in place, which indicates change in the
trend of the T-bond market.
FIGURE 2: DAILY VALUE LINE CONTINUATION CONTRACT. When the market completed
parameter 6A, it forewarned of a market decline.
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FIGURE 3: MARCH 1989 SOYBEAN OIL. Here's another example of the 6A parameter indicating the
beginning of a downturn.
FIGURE 4: MARCH 1989 COFFEE. This time, the market rallied during the day after the 6A parameter,
but the market still closed lower that same day.
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FIGURE 5: DECEMBER 1991 DEUTSCHEMARK. The sell signal in this example was perfect.
FIGURE 6: OCTOBER 1993 SUGAR.The sell signal occurred on May 17 for the sugar market.
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FIGURE 7: MARCH 1994 CANADIAN DOLLAR. The 6B parameter was met one day after the top.
FIGURE 8: WEEKLY COCOA CONTINUATION CONTRACT. Here's weekly chart that showed a sell
signal using the 6A parameter.
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