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Stochastic Momentum
by William Blau
A new twist on the venerable stochastic formula was presented in a January 1991 article,
"Double-smoothed stochastics," written by William Blau. Here, Blau expounds on stochastic double
smoothing in a somewhat different form that emphasizes momentum characteristics.
D ouble smoothing of both numerator and denominator of the original formula for %K of the stochastic
indicator aids in obtaining low-lag smooth-contoured indicator curves. In lieu of a single parameter to
specify the stochastic, the Ds-stochastic formulation provides an additional two parameters for a
double-EMA (exponential moving average) effect. The Ds-stochastic formula is given by:
E s ( E r (Close − LL: q ))
DS(q , r , s) = 100
E s ( E r ( HH: q − LL: q ))
HH:q- LL:q, assumed by the price bars in a lookback of q-bars. The raw stochastic formula,
Ds(q,1,1),represents where the current close is relative to the low point of the stochastic range. A close
near the upper portion of the range will be near the highest high in the most recent q-days, for example.
Figure 2 shows the same train of high, low and close price bars but with different annotations. The
stochastic range remains unchanged. The close is now referenced to the midpoint, 0.5 (HH:q + LL:q), of
the range.
The distance of the current close from the midpoint defines stochastic momentum as
E s ( E r (SM(q ))
SMI(q , r , s) = 100
0.5( E s ( E r ( HH: q − LL: q )
where:
q,r,s parameters while holding the remaining parameter fixed. Smoothing is readily evident in the r,s
parameters because the represent direct exponential moving averages. Smoothing is also intrinsic to the
q-parameter describing the stochastic momentum, SM(q). See Figure 5 for the smoothing effect of the
cumulative sum of the stochastic momentum. The result is comparable to taking an EMA directly on the
close.
to trend as prices trend. (The slow stochastic is retained for comparison.) The major turning points are
highlighted in a timely manner with lag less than, or equal to, that produced by the same moving average
applied directly to price. Divergences now appear at B, C, D, E and F. A divergence from the beginning
of B to C signals the end of a rally in prices, or the beginning of a decline. At A, the slope of the SMI
trends up with prices. At A, the slow stochastic remains noisily flat in an over-bought region. As shown,
the stochastic momentum index is slowly varying, showing price trends, major turning points and
labeling of turning points via divergences with price.
The slow stochastic may now be used as an entry (or exit) vehicle for trading with the stochastic
momentum index defining the trend of prices. An example can be seen in Figure 11 for an SMI(q,r,s) =
SMI(20,60,1) defining the trend and a 20-day slow stochastic. Note the smoothness of the S MI due to the
increased smoothing to an EMA of 60 days with essentially very little lag introduction of the major
turning points.
L ong trends are often troublesome to those indicators that are inherently oscillators. Broadly speaking,
when the time duration of the trend exceeds the indicator's natural period of oscillation, the indicator may
not properly show the trend direction. Figure 12 depicts such a situation. The lag is determined by the
smallest value of q, r in the stochastic momentum index, SMI(q,r,s). The turning points to be retained, the
"major" turning points, are filtered by the largest value of the double smoothing (q,r) parameters. In
Figure 12, the anomaly of having a downtrend in prices erroneously indicated is corrected by increasing
the r parameter from 20 to 150.
TWO-DAY STOCHASTICS
When q=2, there are two price bars in the lookback period as shown in Figure 13. Both the Ds-stochastic
and the stochastic momentum index are described. The latter is more appropriate for our present
purposes, as it permits the use of stochastic momentum, which here becomes:
extreme prices today and yesterday. Note the sudden drop in the response of the S MI(2,40,20).
ONE-DAY STOCHASTICS
When q = 1, the nomenclature suitable for Ds-stochastics and the stochastic momentum index is shown
in Figure 17. With a lookback of q = 1 bar, the stochastic momentum is defined within the highest high
and lowest low of the day:
E s ( E r (SM(1))
SMI(1, r , s) = 100
0.5( E s ( E r ( high − low )))
The one-day stochastic is sensitive to the location of the close relative to the high and low of the day.
This characteristic is useful as a sentiment, or trend identification, indicator, such as in Figure 18, where a
true strength index, TSI(close,100,20), is compared with a stochastic momentum index, SMI(1,100,20),
for a 20-minute December S&P 500 futures contract. The TSI is seen to track the close-to close variations
of the price curve: up, down, sideways. The one bar stochastic, on the other hand, gives more of a sense
of the overall direction of the market. Often, the one-bar stochastic may be used as a direct trading
vehicle signaling major turning points on a smooth and timely basis.
In Figure 19, the 20-minute price curve is shown with up sentiment as indicated by SMI(1,40,20). A
TSI(close,40,20) curve is included for comparison. The TSI curve tracks the close-to-close prices and is
greatly affected by the gap opening. The one-bar stochastic is unaffected by the gap opening continuing
its rise from one day to the next.
William Blau, (407) 368-9095, is an independent futures trader.
REFERENCES
Appel, Gerald [1985]. The Moving Average Convergence-Divergence Trading Method, Advanced
Version, Scientific Investment Systems.
Blau, William [1991]. "Double-smoothed stochastics," Technical Analysis of STOCKS &
COMMODITIES, Volume 9: January.
___ [1991] . "True strength index ," Technical Analysis of STOCKS & COMMODITIES, Volume 9: November.
___ [1992]. "Trading with the true strength index," Technical Analysis of STOCKS & COMMODITIES, Volume
10: May.
___ [1991] . "True strength index & double-smoothed stochastics," presented at the CompuTrac TAG14
Technical Analysis Seminar, New Orleans, November 20-22.
Chande, Tushar [1991]. "The midpoint oscillator," Technical Analysis of STOCKS & COMMODITIES Volume
9: November.
Lane, George C. [1984] . "Lane's stochastics," Technical Analysis of STOCKS & COMMODITIES, Volume 2:
Chapter 3.
FIGURE 1: In a lookback period of q-bars, The range of the bars is HH:q-LL:q. The close is referenced
to the low point of the range.
FIGURE 2: In a lookback period of q-bars, HH:q, the range of the bars is HH:q - LL:q. The close is
referenced to the midpoint of the range. Stochastic momentum is defined as: SM(q) = Close - 0.5(HH:q
+ LL:q). SM(q) is positive when close is greater than the midpoint of the range, direction up. SM(q) is
negative when close is less than the range midpoint, going down. Amount of movement of market is
determined by how large SM(q) is relative to its range.
FIGURE 8: SHORTER INTERVAL, ASM & SMI. A reduction in the stochastic lookback interval to 20
days with five days of smoothing sharpens the turning points and produces divergences in the SMI
relative to price where they did not exist before. Again except for scaling, the ASM and SMI appear very
similar in shape. The differences are due to compression effects in the normalization of the SMI
FIGURE 9: LANE'S SLOW STOCHASTIC AND THE STOCHASTIC MOMENTUM INDEX. SMl(q,5,1)
approximates the slow stochastic in shape and timing with the exception of scaling. The small
differences are mainly due to the five-day EMA in lieu of the three-day SMA built into the %D (q) of the
slow stochastic.
FIGURE 10: INCREASING THE EMA SMOOTHING THE INTERVAL. Increasing the EMA interval to
20 days obtains SMl(q,r,s) =SMI(20,20, 1), which no longer has the appearance of a fast oscilator. The
SMI now appears to trend as prices trend. Divergences appear at B, C, D, E and F. A divergence from
the beginning of B to C signals the end of a price uptrend. Also, at A the slope of the SMl trends with
price. The slow stochastic is shown for comparison; the region A remains noisily flat in an overbought
condition.
FIGURE 11: FURTHER INCREASE OF EMA SMOOTHING INTERVAL. SMI(20,60, 1) produces a very
smooth trendline with essentially no lag introduced for the main turning points(compare with Figure 10).
Divergences exist now only at D. E, F and G. The divergences that were at B and C are now absent.
The major downtrend in March is keyed by the long divergence at G and is further supported by the
slow stochastic divergence at C. The slow stochastic may now be used as an entry (or exit) vehicle for
trading with the stochastic momentum index defining the trend of prices.
FIGURE 12: LONG TRED ANOMALY. In the middle panel SMI(20,20, 1) is timely and smooth.
however, it gives erroneous indications of trends when the price trend is of very long duration. Starting
in April, it indicates an uptrend while, in fact, prices are declining. In the bottom panel SMI(20,150,1)
removes the error so that the indicator again trends correctly with price. Timeliness and smoothness
are present with very little additional lag.
FIGURE 13: Designations for the DS-stochastic and stochastic momentum index formulas are
shown;q=2 defines a two-day stochastic (two daily price bars) .
FIGURE 14: TWO-DAY STOCHASTICS AS A PROXY FOR PRICE . A large interval 300-day moving
average shows the two-day stochastic to be a good approximation of price (bar graph).
FIGURE 15: TWO-DAYS TOCHASTIC ON T-BONDS . The smoothing interval is reduced to 20 days. A
second interval also of 20 days is used to smooth the result of the first smoothing. The effect of double
smoothing is to remove the high-frequency fluctuations and obtain a relatively smooth trending curve
that is timely (low lag) with access to major turning points in prices.
FIGURE 16: KEY REVERSAL PATTERN . Two-day sochastics are sensitive to the location of the close
relative to the extreme of prices today and yesterday. A key reversal pattern has a large displacement
of the close from the extreme (high) today relative to yesterday's extreme (low). An immediat downtum
is generated in the SMI(2,40,20). Compare with a TSl(Close,40,20), which closely tracks the
close-to-close variations in price.
FIGURE 17: Designation for the DS-stochastic and stochastic momentum index formulas are shown; q
=1 defines a one-day stochastic (one price bar).
FIGURE 19: GAPS & GAP OPENING. The gap opening takes time for the EMA(close,20) and
TSl(close,40,20) to absorb. The one-bar stochastic, SMI(1,40,20), is unaffected by the gap continuing
its ascent The overall sentiment is up. Examination of the bars reveals the closes are dominantly above
the midpoint of their 20-minute rangeover the smoothing interval.