Stochastic Divergence Trading

Stochastic Refresher
Stochastics are amongst the most popular technical indicators when it comes to Forex Trading. Unfortunately most traders use them incorrectly. In this section, we will review the correct way to use this popular technical indicator. George Lane developed this indicator in the late 1950s. Stochastics measure the current close relative to the range (high/low) over a set of periods. Stochastics consist of two lines:
%K – Is the main line and is usually displayed as a solid line
%D – Is simply a moving average of the %K and is usually displayed as a dotted line
There are three types of Stochastics: Full, fast and slow stochastics.
Slow stochastics are simply a smother version of the fast stochastics, and full stochastics are even a smother version of the slow stochastics.
Interpretation
Buy when %K falls below the over-sold level (below 20) and rises back above the same level.
Sell when %K rises above the over-bought level (above 80) and falls back below the same level.
The interpretation above is how most traders and investors use them; however, it only works when the market is trendless or ranging. When the market is trending, a reading above the overbought territory isn't necessary a bearish signal, while a reading below de oversold
territory isn't necessary bullish signal.
Trending market
When the market is trending is necessary to adapt the oscillator to the same conditions: When the market is trending up, then the signals with the higher probability of success are those in direction of the trend “Buy signals”, on the other hand when the market is trending down, selling signals offer the lowest risk opportunities. Thus when the market is trending up, we will only look for oversold conditions (when the stochastics fall below the oversold level [below 20] and rises back above the same level) to get ready to trade, and in the same way, when the market is trending down we will only look for overbought conditions (when the stochastics rise above de overbought level [above 80] and falls back below the same level.
Taking all overbought/oversold signals during a trending market will lead us to many whipsaws. If you are not comfortable with the number of signals given, try expanding your trading to other currency pairs.
Trend-less market
During a ranging market we could use the interpretation explained above to trade off stochastics.
Divergence
Divergence trades are amongst the most reliable trading signals in the Forex market. A divergence occurs either when the indicator reaches new highs/lows and the market fails to do it or the market reaches new highs/lows and the indicator fails to do it. Both
conditions mean that the market isn't as strong as it used to be giving us opportunities to profit from the market. Stochastics can also be used to trade off divergences.
Stochastic Divergence
This fantastic money maker was brought to my attention.. We all know how divergence works. If you don’t, please read some explanatory posts online. Divergence occurs when price highs/lows do not agree with the stochastic oscillator highs/lows.
Stochastic Divergence is easy to trade.
All you do is simply wait till a divergence exists, then trade in a particular direction.
Details: Wait till stochastic is below 20 or above 80 for a well defined ‘high probability’ entry. Wait till Stochastic ticks the other way before entry. On a 5 min chart, you will need to keep checking the chart every so often as the indicator touches andbreaks the 20/80 line. If you are able to do this, you will be able to anticipate the divergence and you will be ready as soon as you see a tick in the opposite direction.
See figure for an example.
Stochastic Divergence Trading

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