Table Of ContentStocks & Commodities V. 3:6 (196-199): Trading with ARIMA and stochastics by John F. Kepka
Trading with ARIMA and stochastics
by John F. Kepka
In the June 1985 issue of Technical Analysis of Stocks & Commodities magazine, I presented some
possible strategies using ARIMA (AutoRegressive Integrated Moving Averages) to trade the September
Standard & Poor's (S&P) 500 Futures. The Stochastics Oscillator was discussed in the May and
September 1984 issues of Technical Analysis of Stocks and Commodities. Now, I will combine ARIMA
from daily data, stochastics, and use half hourly Standard & Poor's (S&P) 500 index futures prices. The
half-hourly price data and the stochastics are obtained from Intra-day Analyst, software specifically
designed for intra-day price analysis.
—ARIMA Sets the Day's Range
The ARIMA forecasted highs, lows, and 50% confidence levels were calculated from a model developed
for the S&P 500 September 1984 futures with EASI/ARIMA—The 2%, Solution . I refer to these
forecast levels as potential action points. Both the regular and the slow stochastics are presented for
comparison in Figure 1 along with the price action. Figure 2 lists Daily ARIMA forecasted values.
Recall that the 50's, confidence level provides the upper and lower boundary values peculiarly referred to
as HIHI, LOHI, HILO, and LOLO. Figure 3 depicts the forecasted values (solid line) and the 50%,
boundaries (dotted line) superimposed on the price chart without any studies. Figure 5 displays price
action, forecast prices, and the slow stochastic. Figure 4 illustrates the regular stochastic.
You may want to refresh your stochastic knowledge by referring to the articles by Lane and Schirding
(See Bibliography).I have found that the signals are not nearly as clear in real time as they are in the text
book examples.
Basically, you want to locate stochastic buy or sell signals at or near the forecasted levels. Once positions
are entered, ARIMA levels will be used for stop loss protection. In actual trading, you might elect to take
signals only if the actual crossover occurs (sometimes the crossover occurs after a substantial price move
has already taken place) or you may choose to be more anticipatory in entry signals. You, the trader, must
make the final decision on exactly how you will use these tools. You also have the choice whether to
liquidate a trade on the close or carry it over to the next day in the absence of a reversal signal. t
Before I describe trading signals, here are some observations for using ARIMA forecasts.
1) Prices exceed forecasts in the direction of the trend in force.
2) Openings which exceed the ARHI or ARLO indicate additional strength or weakness.
3) Prices exceeding the HIHI or LOLO indicate exceptional strength or weakness for that day.
4) Stop Loss protection is the LOLO in the case of a long, and the HIHI in the case of a short position.
I consider theses to be the absolute fail safe points.
Stochastic Trading Signals
The signals I'm about to describe may be difficult to understand and the text or description difficult to
follow. Moving averages are simple to understand and use. Unfortunately, they are not necessarily the
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best strategy. You will have to refer to Figure 1 frequently. The important areas of interest have been
lettered to assist you in following along. The calendar dates are shown in Table A. Here too, important
prices are lettered and highlighted or circled. In the text I will refer to the various forecasted values as
HIHI, LOLO, etc.
In the following discussion, I will assume the entry of the appropriate stop-loss protection after a long or
short position.
8/17: On this day prices opened higher and found resistance at the ARHI at 166.994.
A)The 16560 low (A) is 15 points higher than LOHI. This could be the support point since the market
is in an uptrend on daily charts. %D values are rising—bullish. A REG K/D crossover to downside
occurs at 1400. At 1430, Slow K/D crosses over.
(B)A short position could be entered in this area. It is late in the day so the trade may be carried over
into 8/20. This is up to the individual trader. This is a Friday and involves additional risk. If the
position is carried over, the HIHI for Monday will be the first line of defense.
8/20 C) The market opens 10 points above ARHI with %D values declining. Sell short or maintain
existing short position. A new position here would have to be entered quickly. Prices decline to
below the HILO which normally means a test of ARLO.
D)From 1100 to 1300 hours, there is bullish divergence between %D and the lows. Prices are
supporting 30 points above ARLO. The chart pattern is a possible double bottom. Slow K/D
crosses over up and down. (This fluttering can make stochastics tough to test on back data.) The
important points in this area is the proximity of the ARLO support and the rising %D values
(bullish divergence). Go Long.
E) ARHI now becoming resistance. Should be able to liquidate longs no worse than close: 16660. The
question of a short sale arises here also. Prices are at highs and %D values are also at higher levels
than points (B) and (C). I think this type of pattern is a judgment call.
8/21 (F)The Market opens through the ARHI. %D starts rising. REG K/D crosses to plus side at 930.
This market should test HIHI. If short, buy back and go long. In the next time period the prices
break HIHI and close above it. %D reaches new highs. The SPU has clearly broken out to the
upside. The first turn down in %D is at 1130 indicating potential weakness. The market is 175
points above the HIHI. The market is now between "fear and greed". Probably should be looking to
liquidate above 17000.
(G)Price runups are on decreasing %D—bearish divergence. This market could consolidate or react
sharply. If you elect to sell short this kind of market, be prepared to cover quickly.
(H)Prices react 140 points as REG K/D crosses back to plus. Slow K/D takes two periods longer to
cross. Aggressive traders would buy this back no worse than 17000, but it is late in the day. Do not
buy unless you are prepared to take a small loss or carry it over.
8/22:The market opens steady. Re-enter longs. Resistance should not be lower than 17040 and most
likely prices should challenge ARHI since SPU is still in an uptrend.
(I)New highs 25 points below the ARHI with big bearish divergence with %D. This cyclic high
should be compared to %D values at (G). This is a definite sell signal. Liquidate long and sell
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short. You should be able to establish a short between 17100 and 17040. This is also a REG K/D
cross over. The market breaks 185 points from the high in 11/2 hours. d) The market gives another
chance to be short on the retracement to 17050. The end of the rally is (K).
(J)The new lows in %D at a) are a possible "bear set-up" (see Lane's article). The rally to (K) is fast
and the %D shows almost no strength. (During these periods I will go down to 5-minute and
2-minute bar charts and oscillators.)
(K)Retracement high.
(L)At the close the market is very oversold and prices have reacted near HILO. Take the money.
8/23: (L)The market opened higher and immediately sold off finding support 15 points above ARLO.
There is no clear cut K/D signal here. If you were to take action on K/D crossover at 1000 hours,
prices have rallied 85 points from the lows.
(M)Prices reach 35 points below LOHI, a bearish divergence. This could be short sale for a move
back to ARLO. Also the (M) rally with higher 96D readings than (I) may be interpreted as a "bull
set up". Look to key in on the next signal.
(N)K/D crosses over with %D values higher than (L). Cover short and go long. As it happens, the (N)
signal was profitable.
ARIMA and Stochastics
Divergences between %D and price can take place at cyclic highs or lows or at individual points such as
(D) and (G). Also, I have seen a lot of good REG K/D crossovers occur on the left-hand side instead of
the right hand side described by Lane as the most desirable. If prices are near ARIMA support and
resistance, I would be inclined to take the signal. If you use slow stochastics, you will never get right
hand crossovers. The Regular Stochastics is a little messy on a plot, but it does give earlier signals.
I believe a marriage between ARIMA and Stochastics to be potentially rewarding for a trader. I leave the
chore of tallying the potential profits or losses resulting from the simulated trades to the reader. Some of
these comments have been made with benefit of hindsight after studying thousands of price charts with
oscillators. I do employ these guidelines in actual trading.
Will Rogers probably had the best trading approach. To paraphrase him: "Buy stocks that go up. If they
don't go up, don't buy them."
I would be delighted to discuss this or any article further with you. Call at (314) 993-6225 or write to
1601 South Lindbergh Blvd., St. Louis, MO 63131. Good trading to all of you. After all, it's easy—just
like taking candy from a gorilla.
Bibliography
1. Lane, George C., "Lane's Stochastics", Technical Analysis of Stocks and Commodities, May 1984,
Vol. 2, No.3, p. 80.
2. Schirding, Harry, "Stochastic Oscillator", Technical Analysis of Stocks and Commodities, May 1984,
Vol. 3, p. 97.
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3. Lane, George C., "Stochastics and Serial Differencing", CompuTrac Seminar, Toronto, October,
1982.
Figure 1
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Figure 2
Figure 3
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Figure 4
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Figure 5
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