Using Stochastics divergence to identify support and resistance

Using Stochastics divergence to identify support and resistance

Using Stochastics divergence to identify support and resistance

The Stochastics oscillator divergence offers traders one of the most widely used trading set ups where long and short positions could be taken based on the regular bullish/bearish divergence and the hidden bullish/bearish divergence. What many traders fail to realize however is the fact that divergences can also be used to identify key support and resistance levels. Indeed, support and resistance is one of the most basic characteristics of price and is one of the reasons why prices move in a near zigzag fashion and never in a single straight direction.

Most traders often tend to struggle plotting support and resistance levels and in most instances, either the trader ends up plotting the wrong support/resistance levels or over/underestimating the support/resistance levels. Traders know that not all support and resistance levels are equal in importance. So how does one go about plotting these important price levels? In this article, we show you how the Stochastics oscillator’s divergence can be used to identify the key support/resistance levels and how traders can trade off these levels. By the end of this article, the reader would be well equipped to use the oscillator divergence concept and thus be able to plot the support/resistance levels with more confidence.

The Chart Set Ups

For the chart set ups, we simply make use of the Stochastics oscillator where traders can make use of 14, 3, 3 or 5, 3, 3 depending on their preference. The time frame is irrelevant here, but readers should note that the support/resistance levels that are identified are applicable for the time frame you are using. The higher time frame support/resistance levels tend to be a lot stronger than the lower time frame’s support and resistance levels.

The first image below shows the typical chart set up.

1_Divergence-Chart-Setup

Stochastics Divergence Chart Set Up

Once the above chart is set up, the next step is to start identifying the divergences, if any that might have been formed.
For more information, read this article on how to spot divergence.

Stochastics Divergence Support/Resistance Strategy

After spotting the divergences (both regular and hidden divergences), the next step is to plot the highs and lows when the divergence is formed. For example, a bullish divergence where prices make a low and a lower low while the oscillator makes a low and a higher low, using the horizontal line drawing tool, simply mark the two lows on the chart and continue doing so for every divergence that forms thereafter. Make use of at least three divergences on the chart. The next image below shows the resulting chart.

Support/Resistance Based on Stochastics Divergence

2_Divergence-Support-Resistance

In the above picture,

  1. Denotes the hidden bearish divergence based on prices make lower highs and the oscillator making higher highs
  2. Denotes a regular bullish divergence where prices make a lower low while the oscillator makes a higher low
  3. Denotes another bullish divergence based on the lower low in price and higher low in the oscillator

After the above three divergences are formed and plotting the horizontal line, we can notice a confluence of divergence 2’s low and divergence 3’s low. If you look carefully, notice how prices fall back to this level and establish support and then stages a strong rally. Needless to say, the rally’s target is obviously the resistance levels denoted by the horizontal lines plotted from divergence number 1.

The next chart below shows how price action unfolded and also shows the levels where a trader could have taken their positions. Notice that this strategy offers a good 1:2 and higher risk/reward as well with the trade entries coming in at the support while booking profits at the resistance levels above.

3_Divergence-Strategy

Divergence based trade set ups

The next chart below illustrates a short set up, based on identifying three previous divergences on the chart and then plotting the support/resistance levels.

4_Divergence-Strategy-Short

Divergence Setups – Short example

At divergence 4, all the support/resistance levels come to work together with prices failing at the resistance high and forming a bearish divergence. The decline see’s prices falling back to the previously identified support level from divergence number 3.

Strategy Conclusion

The Stochastics divergence support/resistance strategy is relatively simple once a trader gets comfortably in spotting the divergences and beings to plot the support/resistance level. Because this works in real time, a trader needs to be quick to take the opportunities that form as price evolves. While the above might look complex, it is indeed simple and offers a robust risk/reward ratio.


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