How to trade Stochastics Divergence - Advanced Forex Strategies

How to trade Stochastics Divergence

How to trade Stochastics Divergence

About the strategy: The Stochastics oscillator is a versatile trading oscillator which is typically used to buy or sell when the oscillator moves above the 20, oversold level and below the 80, overbought level. As with most oscillators, while the Stochastics works best in ranging or sideways markets, it can also be used to trade the trend by means of identifying divergences. By the end of this article, the reader will have an understanding of what is divergence and how the Stochastics oscillator can be used to signal traders to potential buy/sell signals mostly during a trending market.

What is the Stochastics oscillator and why is it better than other oscillators?

Before going into the Stochastics divergence strategy, a trader should firstly understand how the Stochastics oscillator works and more importantly, why it is a better choice of an oscillator than compared to the others (ex: RSI, Force Index, MACD etc).

The Stochastics oscillator was developed by George C. Lane and is a momentum indicator which is used to identify near term tops and bottoms in the market. The Stochastics simply compares the current closing price in relation to the recent range and is measured by the %K and %D.

It is assumed that during an uptrend, prices make higher closes, nearer to the upper end of the range and prices make lower closes towards the lower end of the range during a downtrend. The Stochastics oscillator therefore determines when price has moved either to the upper or the lower end of the range. This offers traders, a better chance at identifying when prices break out of the previous range, which marks the start of a new or a renewed trend. And when this information is combined with divergence and the prevailing trend, it can be a powerful tool by itself.

Stochastics Oscillator with 5, 3, 3 (fast) settings

The Stochastics oscillator can be categorized into Fast/Slow/Full Stochastics, which is nothing but a change in the variable settings for the oscillator. There really is no major differences between the different Stochastics settings and only varies in terms of sensitivity to price. Some of the commonly used Stochastics settings are 5, 3, 3; 14, 3, 3 and 21, 5, 5. It is up to the trader to pick a setting that they find most comfortable to trade.

1_Stochastics_Oscillator

What is divergence?

Firstly, divergence can be identified by comparing two variables. In the context of trading, these two variables are price and the oscillator. Because the oscillator mirrors price, the general principle is that the highs and lows formed in price should also show confluence (or convergence) with the oscillator. When this convergence fails, it is known as divergence which is a leading signal that points to potential reversals in price. Traders should note that reversals could mean both; a short term reversal or correction or a reversal of trend itself.

2_Stochs_Divergence

The concept of divergence was initially discovered by Charles Dow and was outlined in his Tenets of the Dow Theory where he compared the Dow Jones Industrial Average to the Dow Jones Transportation Index. His theory was based on the fact that when industries produce goods at a steady pace, the transportation of these goods would also keep up the pace. However, when industrial production slows down but transportation remains at the same pace, it signals a divergence, meaning that there would be an eventual slowdown in the industrial production as well. In the context of forex trading, the same above principle is applied but is used by comparing price and the oscillator.

Types of Divergences

3_Divergence_Reference

Regular Divergence: The regular divergence is the easiest and simplest of all and comes in two forms, Bullish divergence and Bearish divergence. The regular divergence occurs more frequently and usually signals a correction in the main trend. It is largely counter trend.

Hidden Divergence: The hidden divergence is a bit more complex than the former, but it is more powerful and comes in two forms, Hidden Bullish divergence and Hidden bearish divergence. When a hidden divergence is spotted on the chart, it signals a correction but goes with the main trend. In other words, a hidden divergence goes with the trend.

The table and the following chart below gives a brief description of the divergence set ups.

Divergence Price Oscillator Direction
Regular Bullish Div. Lower Low Higher Low Up
Regular Bearish Div. Higher High Lower High Down
Hidden Bearish Div. Lower High Higher High Down
Hidden Bullish Div. Higher Low Lower Low Up

Divergence Reference Table

Divergence Setups Examples

Divergence Trade Set ups

After you spot the divergence, either go long or shot when the Stochastics cross above the 20 or 80 level. Stops can be placed a few pips above or below the recent low while take profits can be set to a fixed number of pips or trailed accordingly.

Why should you trade the Stochastics Divergence Set up?

This trading strategy is very versatile and open trading strategy, meaning that it allows a lot of room for traders to combine the Stochastics divergence set up with any other trend following methods. It can be applied to any timeframe. The probability of the trade set ups can be further enhanced by combining with candlesticks (ex: Bullish Engulfing on a bullish divergence set up, and so on). Divergence set ups can also be used to identify support/resistance levels for the timeframe that you are trading this set up.


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