Forex and Stochastic Divergence

As we've spent a couple days looking over the ways to use the stochastic indicator, I hope you have found this helpful. Today we will be returning to the same, but with another tweak.

We've talked already about stochastic over bought and over sold indicators, today let's talk about stochastic divergence. this is an important concept, and one that we will use in the discussions of other indicators to come.

A divergence is when you have two items that formerly moved in one direction together, but now are moving separately. Look at the chart at the top of the blog.

You'll see the price action in the upper frame and the stochastic indicator in the lower one. Look at the areas expressly identified by the blue rectangular boxes and the trend lines.

this is a daily chart of the eur/usd. Remember how I said yesterday that the longer time frames provide the best signals. I will say it over and over. because one of the most common mistakes that new traders make is trading on too short of a time frame. The shorter the chart time, the faster you'll lose your money.

On this chart we see the very end of 2009, and the first quarter of 2010. the outstanding feature of this chart is the fall from the peak at 1.5100 to the current level of 1.3200. That's a drop of 1900 pips. Had you ridden this from top to bottom, that would have been worth $19,000.00 in a standard account. that's a payday.

And believe it or not, the stochastic indicator helped to forecast this movement by the divergence we are talking about today. The blue shaded areas are the time frame from mid October through mid December.

Notice how in that time period of the blue boxes, that the price was still rising. that is clearly reflected by the rising trend line. Then look at the stochastic indicator. You can clearly see that it had declining peaks, contrary to the rising peaks in the price action. this is the divergence. Price headed higher, with stochastics headed lower, forecasts lower prices.

Although we don't show it here, the opposite is true also. Lower price valleys, along with higher stochastic valleys, will often forecast rising prices.

This can be used on smaller time frames as well, just remember the caveat, that smaller time frame produce less reliable signals.

Divergence...one of the keys to forecasting price movement.

Until next time...Happy Trading!

Bill