|Changing parameter values for indicators|
What do the different parameter values really mean to the trader?
Most of us have heard this from someone in our trading past: "You should really use this parameter, it really works." But why? And what do those parameter changes really mean? How does altering these numbers make such a difference? And if you talk to enough traders you end up with an equal number on both sides of the fence. So, in this issue we are going to do our best to explain what these parameters really mean.
Quick overview of the Relative Strength Index (RSI)
The RSI was first published by Welles Wilder Jr. in 1978. His book, New Concepts in Technical Trading Systems, is a must read for any technical trader.
The RSI is an indicator that measures the changes between the higher and lower close prices. These price differences are plotted on a scale from 0-100. (For more details read report on RSI)
The formula to RSI:
It's that 'n' that people keep changing. But what number should you put in? And what is the difference? First, the 'n' represents the number of trading days to be used in the calculations. RSI-14 means there are 14 trading days used in the calculation, and RSI-10 means there are 10 trading days in the calculation and so forth. In actuality, you could put in whatever number you wanted, but changing that number has a dramatic effect on when and if signals occur.
Originally, Welles Wilder Jr. used the 14-day RSI (half a lunar cycle). This was later changed by traders to 10 days (which allows for weekends) and is exactly two weeks. The 14 -day RSI is almost three weeks (there are five trading days per week).
In my opinion, the power of technicals has more to do with the ability to alter these parameters to fit the time frame that suites your trading style, and less to do with the fact that it takes the moon 28 days to circle the earth or because 10 days fit into two business weeks.
Parameters should be based on your trading time frame. A short-term trader needs a more sensitive indicator, using smaller numbers while a long-term trader can use a larger number of trading days in their formula.
To figure out what parameter fits, you need to answer the following questions:
It is important to note that you should test new parameters or indicators with a risk-free paper trading technique or try it in conjunction with your current trading system.
Examples of the different RSI's
The DJIA and the RSI-10 and RSI-14
The DJIA and the RSI-10 and RSI-21
Quick overview of stochastics
The stochastic indicator, developed by Dr. George Lane, is a momentum oscillator that can warn of strength or weakness in the market -- often well ahead of the final turning point. It is based on the assumption that when a stock is rising it tends to close near the high and when a stock is falling it tends to close near its lows.
There are two types of stochastic formulas in practice today. The original stochastic is sometimes referred to as the "fast" stochastic to differentiate it from the "slow" stochastic. Some traders feel the fast stochastic %K line is too sensitive and, to improve their analysis, they replace the original %D line with a new slow %K line. The new slow %D line formula is then calculated from the new %K line. The result is a pair of smoothed oscillators that some traders believe provide more accurate signals.
The slow stochastic is an excellent example of where the strength of parameters can be seen. In the following example I have chosen a 9,3,3 and 21,9,9.
The first number represents the period, this is the time frame which is used to find the highest high and the lowest low (within the last X days, the X is the period). The second number is the moving average to be used in the formula and the third number is the %D.
Once again, the lower the numbers, the more sensitive the indicator becomes to recent events. Larger numbers smooth out the line. This can be seen most easily when comparing a short slow stochastic parameter setup and a long slow stochastic parameter setup.
Examples of the different slow stochastics
The DJIA and the slow stochastic 9,3,3 and 21,9,9
The general rule of thumb with the RSI, slow stochastic or any indicator/oscillator, is that when you increase the parameter, the indicator "smooths out." Larger numbers for parameters make the indicator less sensitive to recent moves and the longer-term trend is more apparent. When you decrease the parameter value, the indicator becomes more sensitive to the recent price moves and allows the trader to react more quickly. The shortfall to this is that the indicator no longer shows the longer-term trend well and may report signals during a correction rather than a breakout (which are what some short term traders are looking for).
TIPS & TECHNIQUES - Using this combination of indicators
The RSI and stochastics work best with a complementary indicator. According to Bollinger, one of the biggest mistakes in technical analysis is the multiple counting of the same information. For example, using different indicators all derived from the same series of closing prices to confirm one another. So always be aware of what an indicator uses for it's calculations and keep a balanced system.
This is not to say that using two of the same type indicator with different parameters isn't helpful. There are quite a few systems that rely on the crosses of multiple identical indicators (for example: the 5 & 20 moving average cross).
In the stochastics indicator example, using both parameter settings can give the trader an edge by identifying both the short-term moves and the long-term trend. Use the parameter 21,9,9 to trade only the major uptrend and use 9,3,3 to swing trade within the uptrend.