Stochastic Oscillator Bullish and Bearish Divergence Trading
Divergence trading is one of the trading signals that can be generated when using the stochastic indicator.
Divergence is a signal that a rally or retracement is losing steam and is likely to reverse. It means that the last buyers or last sellers are pushing the price in one way while the majority of other traders have stopped trading in that way and are cautious of a price correction or retracement.
There are 4 types of divergences.
Example 1: Classic Bullish Divergence
A Bullish Divergence in the stochastic and the price is followed by a rise in price.
When the price is making new lows the Stochastic indicator is not moving past its previous lows it is an indication that the down trend is about to reverse and a bullish rally is likely to occur.
In the example above the price set a new low but it was not coupled with a new low in the measure of Stochastic, when price formed a new low then the indicator should have followed suit, but the stochastic did not therefore the divergence.
This setup is even stronger because there is combination of a divergence and then followed by a rise above the 20% level. This combines the Overbought and Oversold levels.
Example 2: Classic Bearish Divergence
A Bearish Divergence in the stochastic and the price is followed by a drop in price.
When price is making new highs but the Stochastic is not moving beyond its previous high it is an indication the uptrend will reverse and that a bearish divergence will follow.
This setup is even stronger because there is a combination of a divergence with a dip below the overbought 80 level.
Example 3: Hidden Bullish Divergence
This setup signifies a retracement in an upward trend. This is the best type of divergence to trade, because you are not trading a price reversal, but you are trading within the direction of the Forex trend.
Even though, the stochastic oscillator made a lower low the price low was higher than the previous low (higher low). This means that even though the sellers made a good attempt to push price down as indicated by the stochastic, this was not reflected on the price, and the price did not make a new low. This is the best place to buy the currency, since it is even in an upward trend there is no need to wait for a confirmation signal, because you are buying in an upward Forex trend.
Example 4: Hidden Bearish Divergence
This setup signifies a retracement in a downward trend.
This is the best type of divergence to trade, because you are not trading a price reversal, but you are trading within the direction of the trend. This is the best place to sell currency, since it is even in a down trend there is no need to wait for a confirmation signal, because you are selling in a downward Forex trend.