## Stochastic Modeling

## What Is Stochastic Modeling?

Stochastic modeling is a form of financial model that is used to help make investment decisions. This type of modeling forecasts the probability of various outcomes under different conditions, using random variables.

Stochastic modeling presents data and predicts outcomes that account for certain levels of unpredictability or randomness. Companies in many industries can employ stochastic modeling to improve their business practices and increase profitability. In the financial services sector, planners, analysts, and portfolio managers use stochastic modeling to manage their assets and liabilities and optimize their portfolios.

## Understanding Stochastic Modeling: Constant Versus Changeable

To understand the concept of stochastic modeling, it helps to compare it to its opposite, deterministic modeling.

### Deterministic modeling produces constant results

Deterministic modeling gives you the same exact results for a particular set of inputs, no matter how many times you re-calculate the model. Here, the mathematical properties are known. None of them is random, and there is only one set of specific values and only one answer or solution to a problem. With a deterministic model, the uncertain factors are external to the model.

### Stochastic modeling produces changeable results

Stochastic modeling, on the other hand, is inherently random, and the uncertain factors are built into the model. The model produces many answers, estimations, and outcomes—like adding variables to a complex math problem—to see their different effects on the solution. The same process is then repeated many times under various scenarios.

## Who Uses Stochastic Modeling?

Stochastic modeling is used in a variety of industries around the world. The insurance industry, for example, relies heavily on stochastic modeling to predict how company balance sheets will look at a given point in the future. Other sectors, industries, and disciplines that depend on stochastic modeling include stock investing, statistics, linguistics, biology, and quantum physics.

A stochastic model incorporates random variables to produce many different outcomes under diverse conditions.

## An Example of Stochastic Modeling in Financial Services

### How It’s Used in the Investment Industry

Stochastic investment models attempt to forecast the variations of prices, returns on assets (ROA), and asset classes—such as bonds and stocks—over time. The Monte Carlo simulation is one example of a stochastic model; it can simulate how a portfolio may perform based on the probability distributions of individual stock returns. Stochastic investment models can be either single-asset or multi-asset models, and may be used for financial planning, to optimize asset-liability-management (ALM) or asset allocation; they are also used for actuarial work.

### A Pivotal Tool in Financial Decision-Making

The significance of stochastic modeling in finance is extensive and far-reaching. When choosing investment vehicles, it is critical to be able to view a variety of outcomes under multiple factors and conditions. In some industries, a company’s success or demise may even hinge on it.

In the ever-changing world of investing, new variables can come into play at any time, which could affect a stock-picker’s decisions enormously. Hence, finance professionals often run stochastic models hundreds or even thousands of times, which proffers numerous potential solutions to help target decision-making.

## Learn How To Use The Stochastic Indicator Step By Step

#### Learn How To Use The Stochastic Indicator Step By Step

I am always astonished that many traders don’t really understand the indicators they are using. Or, even worse, many traders use their indicators in a wrong way because they have never taken the time to look into it. In this article, I will help you understand the STOCHASTIC indicator in the right way and I will show you what it does and how you can use it in your trading.

## What is the Stochastic indicator?

The STOCHASTIC indicator shows us information about momentum and trend strength. As we will see shortly, the indicator analyses price movements and tells us how fast and how strong the price moves.

This is a quote from George Lane, the inventor of the STOCHASTIC indicator:

*“Stochastics measures the momentum of price. If you visualize a rocket going up in the airВ вЂ“ before it can turn down, it must slow down. Momentum always changes direction before price.” – George Lane, the developer of the Stochastic indicator*

## What is momentum?

Before we get into using the Stochastic, we should be clear about what momentum actually is.

Investopedia defines momentum as “** TheВ rateВ ofВ accelerationВ ofВ theВ priceВ ofВ aВ security**.” viaВ Investopedia

I am always a fan of going into how an indicator analyzes price and without getting too deep into the mathematics, this is how the indicator analyzes price:

The stochastic indicator analyzes a price range over a specific time period or price candles; typical settings for the Stochastic are 5 or 14 periods/price candles. This means that the Stochastic indicator takes the absolute high and the absolute low of that period and compares it to the closing price. We will see how this works with the following two examples and I have chosen a 5 period Stochastic which means that the Stochastic only looks at the last 5 candlesticks.

## Example 1: AВ high Stochastic number

When your Stochastic is at a high value, it means that price closed near the top of the range over a certain time period or number of price candles.

The graphic shows that the low was at $60, the high at $100 (range of $40) and price closed almost at the very top at $95. The Stochastic shows 88% which means that price only closed 12% (100% – 88%) from the absolute top.

**How a high Stochastic is calculated: **The lowest low of the 5В candles: $ 60

The highest high of the 5В candles: $ 100

The close of the last candle: $95

The value of the Stochastic indicator: [(95 вЂ“ 60 ) / (100 вЂ“ 60)] * 100 = 88%

You can see, the high Stochastic shows us that price was very strong over the 5В candle period and that the recent candles are pushing higher.

## Example 2: AВ low Stochastic number

Conversely, a low Stochastic value indicates that the momentum to the downside is strong. In the graphic we can see that price only closed $5 above the low of the range at $50.

**How a high Stochastic is calculated **The lowest low of the 5 candles: $ 50

The highest high of the 5 candles: $ 80

The close of the last candle: $55

The value of the Stochastic indicator: [(55 вЂ“ 50 ) / (80 вЂ“ 50)] * 100 = 17%

The Stochastic of 17% means that priceВ closed only 17% above the low of the range and, thus, the downside momentum is very strong.

## Overbought vs Oversold

The misinterpretation of overbought and oversold is one of biggest problems and faults in trading. We’ll now take a look at those expressions and learn why there is nothing like overbought or oversold.

**The Stochastic indicator does not show oversold or overbought prices. It shows momentum**.

Generally, traders would say that a Stochastic over 80 means that the price is overbought and when the Stochastic is below 20, the price is considered oversold. And what traders then mean is that an oversold market has aВ high chance of going down and vice versa. This is wrong and very dangerous!

As we have seen above, when the Stochastic is above 80 it means that the trend is strong and not, that it is overbought and likely to reverse. A high Stochastic means that the price is able to close near the top and it keeps pushing higher. A trend where the Stochastic stays above 80 for a long time signals that momentum is high and not that you should get ready to short the market.

The image below shows the behavior of the Stochastic within a long uptrend and a downtrend. In both cases, the Stochastic entered вЂњoverboughtвЂќ (above 80), вЂњoversoldвЂќ (below 20) and stayed there for quite some time, while the trends kept on going. Again, the belief that the Stochastic shows oversold/overbought is wrong and you will quickly run into problems when you trade this way. A high Stochastic value shows that the trend has strong momentum and NOT that it is overbought.

## The Stochastic signals

Finally, I want to provide the most common signals and ways how traders are using the Stochastic indicator:

**Breakout trading:**When you see that the Stochastic is suddenly accelerating into one direction and the two Stochastic bands are widening, then it can signal the start of a new trend. If you can also spot a breakout out of sideways range, even better.

**Trend following**: As long as the Stochastic keeps crossed in one direction, it shows that the trend is still valid.**Strong trends:**When the Stochastic is in the oversold/overbought area, don’t fight the trend but try to hold on to your trades and stick with the trend.

**Trend reversals:**When the Stochastic is changing the direction and leaves the overbought/oversold areas, it can foreshadow a reversal. As we’ll see, we can also combine the Stochastic with aВ moving average or trendlines nicely.**Important**: when we look for a bullish reversal, we need to see the green Stochastic line to get above the red one and leave the overbought-oversold area.

**Divergences**: As with every momentum indicator,**divergences**can also be a very important signal here to show potential trend reversals, or at least the end of a trend.

## Combining the Stochastic with other tools

As with any other trading concept or tool, you should not use the Stochastic indicator by itself. To receive meaningful signals and improve the quality of your trades, you can combine the Stochastic indicator with those 3 tools:

**Moving averages**: Moving averages can be a great addition here and they act as filters for your signals. Always trade in the direction of your moving averages and as long as price is above the moving average, only look for longs – and vice versa.

**Price formations:**As breakout or reversal trader, you should look for wedges, triangles and rectangles. When price breaks such a formation with an accelerating Stochastic, it can potentially signal a successful breakout.**Trendline**: Especially Stochastic divergence or Stochastic reversal can be traded nicely with**trendlines**. You need to find an established trend with a valid trendline and then wait for price to break it with the confirmation of your Stochastic.

## Recap: How to use the Stochastic indicator

You might not need the Stochastic indicator when you are able to read the momentum of your charts by looking at the candles, but if the Stochastic is the tool of your choice, it certainly does not hurt to have it on your charts (this goes without a judgment whether the Stochastic is useful or not).

More importantly, this article is meant to make you realize how little you might know about the tools you use for your trading. Additionally, there is a lot of wrong knowledge being shared among traders and even widely used tools such as the Stochastic indicator is often misinterpreted by the majority of traders. Do not blindly believe what other people tell you, do your own research and build your trading knowledge.

## Stochastic Modelling – How to use Stochastic trends

Published on July 29, 2020

###### by Gino D’Alessio

## How to use Stochastic modelling

**Third parameter: Slow/Fast**

The original stochastic oscillator as introduced by George Lane uses a “Fast Oscillator” as the %K is drawn on the chart according to the calculation shown in Part 1. The chart below shows how this oscillator looks. As you can see, the %K line which is the light blue line is very volatile and can lead to many false readings.

Whereas, adding a smoothing factor to the %K line, we get the less volatile line referenced in Part 1. This is achieved by calculating the %K as a simple moving average (SMA) of %K. The common number to use for the look-back period is 3, known as a “*Slow Stochastic*.” However, again I feel that experimentation with this number can lead to better results. In the above chart, the %K line is slowed using a simple moving average of 8 periods, while %K is calculated over 14 periods.

Probably out of the need to simplify the first oscillators used 3 periods in their SMA calculations. Nowadays all technical analysis software will allow you to assign a number of your choice for the look-back period for the %K as well as the number of periods to smooth the %K and for the %D.

**How to use the oscillator**

Looking at the chart below we can see how this indicator flows up and down as the price of crude oil (in this example) fluctuated in one direction and then the other. One trigger that tells us when we should be looking to go long or short is **cross-overs** of the %K line with the %D line. When the oscillator is closer to the higher boundary and crosses the %D line to the downside, you should be considering *short positions*. In the chart, these signals correspond to the areas marked A, B, and C.

When the %K line is in the lower part of the boundary and crosses the %D line from below (on an upwards trend) then you should be looking to consider *long positions*, these points correspond to the areas marked with the numbers 1 and 2.

The crossovers must penetrate through the level of 80 to the downside and the lower level of 20 to the upside. When there is a strong rally or rout the %K line may cross the %D line various times while remaining above 80 or below 20. The signals that occur on those areas of the chart are not to be taken into consideration, as the momentum is still extremely high and it is likely that the direction of the market will continue. These levels at 80 and 20 have long been established as “thresholds”, so users of Stochastics will always take notice as the value passes through these levels.

The stochastic oscillator is a great tool, and modern software is powerful enough to allow us to play around with the parameters to tweak this indicator to give the best results for each time frame and market. Again, it is not by any means a stand-alone tool, which goes for many other technical analysis theories too. It will always create a more powerful analysis when used in conjunction with other tools.

Similarly to other momentum and price action measures, stochastic values can be checked across multiple timeframes to either back up, or perhaps warn against, particular trades. They are a useful addition for traders to add to their list of tools. Most charting available with online brokers will include some technical analysis tools which can be toggled on or off, so it is worth taking a quick look at these oscillators when the opportunity arises.

Read Part 1 of our Stochastic definition here.

The charting features at IG, include Stochastic Oscillators, with configurable parameters;