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:

RSI=100-(100/(1+RS))
and
RS=(average of 'n' days that close up) / (average of 'n' days that close down)
where
RSI = relative strength index
n= predetermined number of days

The parameter:

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:

Are you a short-term trader? Using smaller numbers for your parameter will make the indicator more sensitive to recent price moves and trigger signals more often. However, the older data is ignored (it is more difficult to apply the longer term trend lines). So if you trade a longer term and use a small parameter, you can be whipsawed. It is also more difficult to draw accurate trend lines since the indicator is more volatile (moves quickly up and down).
Are you a long-term trader? Using larger numbers for your time frame ensures that older prices movements are still accounted for. Signals are generated less often and sudden price movements are averaged out. On the flip side, the larger your parameter, the less sensitive the indicator and you may miss your opportunity (since it shows up less often in screeners) or react late.

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.

Signals given by the RSI

Extreme values:

Crosses extreme values, 70/30. The 70% and 30% levels are used as warning signals. An RSI above 70% is considered overbought and below 30% is considered oversold.

Double Tops and Bottoms

Traders watch for double tops or what Wilder referred to as "failure swings." If the RSI makes a double top formation, with the first top above 70% and the second top below the first, you get a sell signal when the RSI falls below the level of the dip. Conversely, a double bottom at or below 30% (with the first low below 30% and the second at or above the same level) gives you a buy signal when the RSI breaks above the previous peak.

Divergences and Convergences

Trend of the RSI relative to the trend of the price is where a trader sees the convergences or divergences. A convergence is when the price is downtrending, yet the RSI begins to uptrend (the to lines converge). A convergence is used as bullish warning signal to the trader. A divergence is then the price is uptrending and the RSI begins to downtrend (the lines separate). The divergence is a bearish warning signal.

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.

Signals given by the slow stochastic

The Stochastic Oscillator generates signals in three main ways:

Extreme values when the 20% and 80% trigger lines are crossed. Buy when the stochastic falls below 20% and then rises above that level. Sell when the stochastic rises above 80% and then falls below that level. The pattern of the stochastic is also important; when it stays below 40-50% for a period and then swings above, the market is shifting from overbought and offering a buy signal. And vice versa when it stays above 50-60% for a period of time.
Crossovers between the %D and %K lines. Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line. Beware of short-term crossovers. The preferred crossover is when the %K line intersects after the peak of the %D line (right-hand crossover). Crossovers often provide choppy signals that need to be filtered through the use of other indicators.
Divergences between the stochastic and the underlying price. For example, if prices are making a series of new highs and the stochastic is trending lower, you may have a warning signal of weakness in the market.

For a more conservative approach, extreme values should be used as the warning signals and the follow through the 50 line for the confirmation of the trend change. Some traders also state that by moving the extreme values to the 10 and 90 lines ensures a more reliable signal.

Examples of the different slow stochastics

The DJIA and the slow stochastic 9,3,3 and 21,9,9

Summary:

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.