stochastics. Let me first describe what divergences are.
One of the most popular modes of using stochastics is divergences. A
divergence occurs when the price and stochastics diverge from following
roughly the same path. In other words, if the price makes a new high but
the stochastics don’t, you have a divergence. If the stochastics make a new
high but the price doesn’t, you have a divergence. Divergences are mainly
used to predict and trade a change in trend.
The typical divergence is when the price makes a new low but the
stochastics don’t or the price makes a new high and the stochastics don’t.
In other words, the momentum of the price is less strong than the price
itself.
There are no specific entry and exit rules but I’ll show you how to use
stochastic divergences to create massive profits. We’ll have to use other
techniques to actually create the timing. We’ll use stochastics to create the
environment for making extra money.
I have studied this type of divergence and have found that divergences
on the daily chart mean something different than divergences on
the weekly chart. Divergences on the daily chart typically mean only that
the market will likely have a short-term countertrend move. In general, I
look for the market to change direction in one to five days (but most likely
in two to three days) and have a one-to-five-day countertrend move (but
most likely a two-to-three-day countertrend move).
A weekly divergence usually means that an intermediate-term trend
change is about to happen. At the least, a weekly divergence means that
there will be a significant countertrend move. I think that the size of the
countertrend moves on the daily chart is not powerful enough to overcome
the countertrend nature of the trade as well as the problem of deciding
when the countertrend will begin.
On the other hand, the size of the projected weekly countertrend or
new trend move was substantial and very tradable. There still remained
the problem of being able to predict when the divergence would actually
create the resulting change in trend. Nonetheless, a weekly divergence is
far more tradable than a daily divergence.
It is a common belief that divergences do predict changes in trend,
even if only a short countertrend move. But it is important to realize that
you can’t simply buy or sell when the divergence occurs. In virtually all
cases, the market continues its trend for several more bars before succumbing
to the power of the divergence. Many traders point out how great
divergences called highs and lows but few, if any, argue that the divergence
actually lasted for some period of time before the price turned direction.
Let’s look at a couple of examples.
In Figure 5.3, we see the price make a significant low about nine bars
from the left (mid-December). The stochastics also make a low. However,
six bars later, the market makes a new low close while the stochastics
have not.
Note that I said a new low close, not a new low. That is because the
relationship of the closes to the closes is the important factor, not the relationship
of the lows to the lows. This is because stochastics are based on
the closing price.
In this case, there was stochastic divergence but the price did not make
a new significant low for three more bars. In our study, the divergence
came three days in advance of the actual bottom. We then measure the
distance from the actual bottom to the subsequent high to get an idea of
the magnitude of the countertrend move. We measure this as a percent of
the price of the underlying instrument to normalize the study over many
futures contracts. For example, a move from 100-00 to 101-00 on the bonds
would equal 1 percent. Obviously, this is not perfect, but it is still indicative
of the magnitude when tested over 30 futures contracts.
Look at Figure 5.3 again and you will see several other divergences.
The most significant one is the one about three-quarters through the chart.
The market leaps to a new high with a very wide range bar but the stochastics
do not make new highs. Eventually, a high is made and the market sells
off but not before mounting a very strong rally.
In our study, we went back over one year of data on about 30 different
commodities. These commodities were in various types of markets: bull,
bear, and chop city. As a result, we get a good indication of the validity of
using stochastic divergences.
First, we tested divergences on daily charts. We found 58 different
divergences. They led a turn in the market by an average of 4.5 days with
a standard deviation of 5.7. However, the mode was only 1 and the median
was 2. The longest lead time was 22 days. As you can see, the lead time
of daily divergences was random. This tends to reduce the value of daily
divergences.
There were obviously 58 retracements from these 58 divergences. The
average percentage retracement was 5.9 percent in a range of essentially
0 to a 21 percent retracement. The mode was 4 percent, and the median
was 5 percent; the reliability of the retracement figures seems reasonable
even though the standard deviation was 4.4 percent.
There were a lot more weekly divergences than daily divergences. We
counted 124 during our sample period. They led turning points by an average
of 2.8 weeks with a standard deviation of 3.4 weeks. The range was
from calling the turning point exactly to 16 weeks in advance. Actually, the
mode was calling the exact turning point. In other words, the most common
occurrence of a weekly divergence was that week was the actual turning
point, which is very interesting to me.
The average retracement of the 124 retracements was 15.3 percent with
a standard deviation of 13.6 percent. Obviously, this is a far more powerful
indicator of subsequent price movements than the daily divergences. The
mode was, however, only 4 percent with a median of 11 percent though the
maximum was 80 percent. Talk about a big move!
I’m about to say something that is astounding and perhaps heretical:
It could be that divergences are simply illusions. Perhaps we are creating
a pattern where none exists. For example, I could create a system that
predicted a countertrend move soon after every day named Tuesday. Well,
sure enough, this system will call 98 percent of every countertrend move
within two weeks. In other words, only rarely will a market go two full
weeks without retracing at least one day. Be aware of this potential problem.
Having said that, I continue to use stochastic divergences on the daily
and particularly on the weekly charts because I am making money using
them.
A failure occurs when the %K changes direction, doesn’t cross the %D,
and reverses back to the original direction. Figure 5.4 shows two different
failures. Arrows in the stochastic part of the chart show the failures. The
first one occurs in early March when the %K actually drops but does not
actually cross the %D. The second one occurs in late April. This is not a
classic failure because it doesn’t actually drop but it doesn’t sharply slow
and almost cross the %D. They often occur when there is a sharp retracement
against the main trend but then an equally sharp resumption of the
main trend.
The classic interpretation is that failure shows that the original trend
will continue and that you should trade in that direction. In this case, that
means jumping in the direction of the trend as soon as the %K resumes its
original trend.
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
