Moving Average Convergence Divergence and Stochastic oscillator – Divergence System

The Moving Average Convergence Divergence and Stochastic oscillator – Divergence System:
Is  another fantastic  way  to  trader  the  longer term  1  hour  and
up  charts.  I  have personally manually back tested this system on
many currency pairs. Some perform   better   than others GBPUSD is the
best followed by EURUSD.All other are still profitable but the above 2
pairs are the superstars.

MACD divergence:
Now
I know from experience that MACD divergence is not easy to understand
and spot straight away, especially for newbie’s.However please be
patient as the patterns will jump out at you eventually.

First
lets  take  a  look  at  the  MACD,  below is  a  picture  of the  MACD
indicator. MACD  is  probably  the  most  common  indicator  ever  used
next to moving averages so you should not have any problem locating it
on your charting platform.

As
you  can  see  it  forms  waves  up  and  down  like  hills  and
valleys.Now let’s have a look at MACD along with price. If you look at
fig 1 below you can see that the MACD does not always follow price there
are  occasions  where  MACD  will  show  a  lower  high  or  a  higher
low while  price  is  doing  the  opposite.These
patterns  are  signals  that price  is  running  out  of  steam  and
may  change  direction  soon. Can you spot it on the image above?

The moving   or   spreading   apart   in   different   directions   from   a common point.In trading, “Divergence” is a term used to describe the phenomenon of price making one pattern, and an indicator making the opposite.

Let’s  look  at  fig  1.1  below  with  the  divergence  pointed  out.On  the chart fig 1.1 you can see I have marked that price is making a lower low while MACD is  making a higher low.This is divergence and we are  going to  exploit  it.For  it  to  be  a valid  MACD divergence  MACD must make a clear lower high or higher low consisting of two hills with a valley between.

Below in fig 2 I have marked another example of MACD divergence price  made  a  higher  high  move  while  MACD  made  a  lower  low indicating that price is out of steam and due for a small reversal.

You can find MACD divergence on basically any time frame, all of the above were on the GBPUSD 1 hour charts. If you are totally lost with finding  divergence  then  I  recommend  you  do  a  Google  search  for MACD divergence and look at some more explanations.

Stochastic oscillator:
The stochastic oscillator measures over bought and over sold situations in the market. We are going to use this as our entry into a divergence setup. Below is a picture of the stochastic oscillator, we will be using the setting K%9 D%3 Slowing 3.

The  upper  and  lower  horizontal  lines going  across  the  oscillator  are our trigger lines. These lines are set at the values of 20 and 80.What  we  are  basically  looking  for  is  the  stochastic  oscillator  to  be over bought above the 80 line if we are planning on going short and over  sold  below the  20  line if we  are  going  long.

Let’s say we  have MACD divergence and we are looking to go long we then have to wait for the stochastic to go below the 20 line see example drawing below.

Once  the  fast  stochastic  line  has  passed  though  the  20  line  you MUST wait for the current candle to finish to ensure it is a cross. The same rules apply to the 80 line for a sell trade.

You  may  be  thinking  how  do  I  tell  which  is  the  fast  line  on  the stochastic?  Well  its  easy,  it  will  be  the  fist  one  to  pass  through  the lines the slow stochastic will be behind it.

Once you have added this to your chart with the MACD indicator lets go  over  the  rules  of  the  system  and  start  looking  at  some  actual trades.

 

System Rules:
The rules to this system are short and simple, I am going to list them below in the order before you can take a trade:
1.  Look for MACD divergence against price. Price must be making higher highs or lower lows while MACD is doing the opposite. 
2.  Stochastic must be below the 80 line if you are looking to buy or above the 20 line if you are looking to sell. 
3.  Open trade once the fast stochastic line has passed though the line and THE CANDLE HAS CLOSED. Check that price has not already moved along way in your direction, if so you may want to consider leaving the trade. 
4.  Place your stop behind the most recent high/low or if that is too far set a stop x number of pips away. Usually around 30 pips if you are on the 1 hour charts.
5.  Once price has gone in your favor by the same amount that you risked and the stochastic has moved to the other side you may want  to  consider  moving  you  stop  to  break  even  or  protecting some profit. I generally trail my stop and try to shoot for twice what I risked on the trade.Trade Examples:
In fig 3 below there was a higher high on price while MACD formed a lower low. Once we see this all we have to do is wait for stochastic to move above the 80 line so we can initiate our short trade.

The White arrow  pointing  down  on  fig  3  is  the  point  at  which  stochastic  went above the 80 line and the candle closed. On the open of the very next candle we open our sell trade with the stop above the high point.

Below  in   fig   4  there   is   another   example   of   a   divergence   trade:And remember you can’t make the trade until the candle has closed!

Below in fig 5 is another example.

Below is another example but in this example we had two setups that worked out very well.

Conclusion:
Although  this  system  trades  against  the  trend  which  is  something  I normally would not advise It has proven to be very profitable over the past few years that I have used it. I have found the 1 hour and 4 hour to  be  my  favorite  time  frames  to  trade  and  I  keep  an  eye  on  a  few pairs to give me plenty of options.

Many  people  struggle  when  first  learning  to  spot  divergence,  don’t worry if your one of them. Keep looking for examples on your charts and compare them to those in this tutorial, it wont be long before you will be trading divergence like a pro and reaping the rewards.

As   with   the   previous   systems   you   will   benefit   greatly   by   using candlestick  formations  as  a  second  confirmation  for  entry  which  will be discussed in my next tutorial.