Stochastic Divergence Strategy

The stochastic indicator can be a great trading tool for spotting market reversals and trend momentum. However, many forex traders just look for a stochastic crossover or extreme level, without even considering a stochastic divergence strategy. I think this can be a very useful way to get additional confirmation on stochastic strategies and to help filter out some false signals.

What is the stochastic oscillator?

The stochastic oscillator is a popular technical analysis tool that indicates momentum by comparing a particular currency pairs closing price to a range of prices over a specific period. It uses range bound values of 0–100 for momentum and has 2 lines for determining the trend direction.

You can use the stochastic indicator on any currency pair or chart timeframe. I like to focus on longer term charts as I find that it helps to filter out some market noise and means that I need to spend less time analysing the markets.

I also prefer trading major currency pairs such as the EUR/USD and GBP/USD. This is because they usually have plenty of liquidity which means tighter spreads and better execution speeds, especially when using an ECN forex broker.

How to use the stochastic indicator?

If the stochastic price is above 80, the market is considered to be overbought. If the stochastic price is below 20, the market is considered to be oversold. If the stochastic main line crosses the signal line in an upwards direction, this is considered a buy signal. If the stochastic main line crossed the signal line in a downwards direction, this is considered a sell signal.


What is stochastic divergence?

Stochastic divergences appear when a new high or low in the currency pair price is not confirmed by the stochastic oscillator. A bullish divergence forms when price on the chart makes a lower low, but the stochastic oscillator is forming higher lows. This indicates less downward momentum that could be a sign of an imminent bullish reversal. Bearish divergence happens when the market price is making higher highs, but the stochastic indicator is making lower lows.

What is the stochastic divergence strategy?

I like to combine both of the stochastic crossover and extreme elements with stochastic divergence. I will try to find a currency pair where the stochastic is around an extreme level and starting to crossover in the opposite direction. I would then try to mark stochastic divergence and keep an eye on price action to confirm my entry. As always, I would mark of what I deem to be any important support and resistance levels to look for price breaking out or rejecting these levels.

Buy signal

  • Stochastic (5,3,3) is around 20 extreme level
  • Stochastic main line crosses up through signal line
  • Stochastic divergence to the upside
  • Price is moving away from recent support or breaching resistance
  • Candlestick charts are showing bullish price action

In the USD/CAD 1-hour chart below you can see that all of the condition for a buy signal have been met. There is clear stochastic divergence to the upside whilst price has bounced from a recent support level. We can see that the stochastic crossover has happened upwards and there is plenty of momentum left in the move as the stochastic is around the 20 level. The trade is confirmed with bullish price action such as an engulfing bar and double bottom candlestick pattern. We could have placed the stop loss just below the support level which is around 35 pips. The price went up over 500 pips which means this trade would have had a very favourable risk to reward ratio.

Stochastic Divergence Strategy Buy Signal
Stochastic Divergence Strategy Buy Signal

Sell signal

  • Stochastic (5,3,3) is around 80 extreme level
  • Stochastic main line crosses down through signal line
  • Stochastic divergence to the downside
  • Price is moving away from recent resistance or breaching support
  • Candlestick charts are showing bearish price action

You can see from the USD/CAD 1-hour chart below that price have bounced away from the recent resistance level. We can see there is clear stochastic divergence to the downside whilst the indicator has also had a crossover to the downside and is around the extremely overbought area. Entry is confirmed with bearish price action including the triangle candlestick pattern. We could have placed the stop loss just above the resistance level which would have been around 25 pips. That is relatively tight when you consider this downtrend continued for almost 300 pips. There was ample opportunity to take profit along the way and other stochastic entry signals to consider.

Stochastic Divergence Strategy Sell Signal
Stochastic Divergence Strategy Sell Signal

Stochastic divergence strategy Pros & Cons

Pros

  • Catch some big currency pair trends
  • Enter at an early opportunity
  • Can be used on any instrument
  • Can be used on any chart timeframe
  • Combine with any other indicator
  • Stochastic oscillator is free to use

Cons

  • Need to filter out false signals
  • Requires good timing for entry and exit
  • Takes some practice to spot stochastic divergence

Conclusion: is the stochastic divergence strategy any good?

Yes, I think the stochastic divergence forex trading strategy can do a good job of identifying new trends early. This means we can catch some big moves and use tight stop losses as it is clear when a trade hasn’t worked out. With a good risk to reward ratio, the win rate does not even need to be that high to still make some pips. Just make sure you use sensible forex money management.


Take your time to practice this stochastic divergence strategy. You could use a free demo account which you can get from most forex brokers. This will allow you to trade forex with virtual funds and improve your skills. Once you have built up enough confidence and start seeing consistent results, you could consider making the switch over to a real live account.

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