Divergence - STOCASTIC DIVERGENCE

The article originally appeared in Ensign Software Newsletter August 2001

To understand a study more thoroughly, it needs to be observed on a theoretical Elliott wave formation.  To often a study is slapped on a chart, adjustable parameters are tweaked, and with the benefit of hindsight some trade signals are derived.  The advanced student might go the extra mile and delve into the mathematics of the study's formula.  But the fundamental behavior of the study is not understood well.  This article will help you understand Stochastic better through an original approach.

The basic concepts of the Elliott Wave Theory are that action is followed by reaction, and there are 5 waves in the main trend, followed by 3 waves in the correction.   Since this pattern is seen over and over in the markets, a theoretical chart based on these principles will be used so Stochastic can be analyzed without market 'noise' obscuring its fundamental behavior.

Various characteristics can be found in the 9 bar slow Stochastic study applied to this theoretical chart.

5 Wave Minor Trend Analysis:  (blue 1-2-3-4-5 small numbers)

1)  The most rapid rise in Stochastic %K (blue line) occurs in minor wave 1.  %K rose from below 20 to 70.

2)  Minor wave 2 caused %K to retrace to %D (red line), but both are still above 50.

3)  Minor wave 3 takes Stochastic higher, with %K reaching a lofty high.  In the real world %K will often reach 80 but rarely 90.   Study tip:  It is important to realize that it is minor wave 3 that takes %K to its highest high!

4)  Minor wave 4 causes %K to cross below %D from its lofty high.  This crossing is the FALSE signal that traders fall for all too often.  Going short because of a turn at 3 is premature, and your stop just above the top at 3 is taken out by the final thrust to the top at minor wave 5.  The psychological tendency is to ignore the signal at 5 because of the loosing short attempted at wave 3.

5)  Minor wave 5 causes %K to rise again, often crossing back above %D, but the market lacks the duration in trend to elevate %K to a higher high.  When %K turns down and crosses %D the second time, this is the signal.   Study tip:  Look for divergence, where the price action put in new highs, but the study does not.   Divergence is marked on the theoretical chart with short red lines.

3 Wave Minor Correction Analysis:  (blue a-b-c letters)

a)  Minor wave  a  returns to the previous support level of minor wave 4.  But the drop of %K is huge, falling from a lofty high to 30.  This rapid fall is similar to the rapid rise that occurred in minor wave 1.

b)  Minor wave  b  is a Fibonacci retracement from  a  back towards 5.  The example has its price stopping at the top of wave 3.  The effect on %K is to rally back to the %D line, but both remain under 50.

c)  Minor wave  c  takes %K to new lows below 30.  The example shows a drop below 20, which would be unusual in the real world for a wave  c  correction.   Study tip:  Divergence will not occur this time.   Therefore, the signal to go long is the first time %K crosses above %D.  This is shown in the example at major waves 2 and 4 (large red numbers) where the market meets the long term support trend line shown in orange.

Signal Summary:

The process starts over again as Stochastic behaves in a similar fashion for major waves 3 and 5 as it did for major wave 1.   The a-b-c correction of major wave 4 will be similar to major wave 2.  The ideal place to short is after major wave 5 is in place, at what will be minor wave 2 of the first trend leg of the new major correction.  This point is highlighted with a yellow circle.

Study tip:  Stochastic had three turns with divergence at the end of major waves 1, 3 and 5 marked in red.   Stochastic turns at the end of the two reaction waves 2 and 4 did not have divergence.   Look for this pattern to help you identify the 5th major Elliott wave.  The divergence signal at the end of wave 5 is the ideal place to go short after a major up-trend, or long after a major down-trend.

Averaging Method:

Now that the fundamental behavior of Stochastic is understood as the Elliott waves develop in a market, the theoretical chart will be used to observe the effect of different parameters on the Stochastic formula.   The first decision is whether to use Exponential or Simple moving averages in the Stochastic calculations.   Both examples shown in the next graph use the same Bar, %K and %D parameters of 9, 3, 3.

Study the patterns in both graphs.  The same fundamental behavior is there, but easier to see with Exponential averaging.  My personal preference is to use Exponential averages in Stochastic.

Bar Parameter:

Now the Bar parameter will be analyzed.  This parameter controls the number of bars in a group that are examined to determine the highest high and lowest low, or range for the group.   A raw Stochastic is calculated by measuring where the last price is in the group's range.  Raw Stochastic = 100 * ( Last - GroupLow ) / GroupRange.  In these examples, the %K and %D parameters will be 3 and 3, using Exponential averages.

Smaller Bar parameters increase the oscillation of the Stochastic.   Larger Bar parameters dampen the oscillation and make it harder to see Divergence.   Study tip:  Select a Bar parameter that is half the average length of the major waves.  The theoretical chart has 24 bars in a major trend wave, and 13 bars in a major correction wave.  The average of these two waves is 18 bars.  So, the 9 Bar parameter gives the best Stochastic pattern.

%K Parameter:

The %K line is an average of the raw Stochastic.  If the raw Stochastic is not smoothed by averaging, then this is called a Fast %K.   The raw Stochastic that is smoothed by averaging is called a Slow %K.   These examples show the effect of the %K parameter on a 9 Bar Stochastic with 3 for the %D parameter using Exponential averages.

The raw Stochastic or Fast %K is very choppy, and for that reason is rarely used.   Having a large %K parameter dampens the Stochastic oscillation.   Study tip:   Use either 3 or 5 as the %K parameter.

%D Parameter:

The %D line is an average the %K line.  The Slow %K line is an average of the raw Stochastic, which makes the Slow %D line an average of the average.  These examples use a 9 Bar Stochastic with 3 for the %K parameter using Exponential averages.

The larger the %D parameter, the more dampened the oscillation of the %D line.   The effect will be to get the signal from %K crossing %D one or two bars later in the turn.   Study tip:  Use 3 as the %D parameter.

Well, that wraps up the analysis for Stochastic.  The theoretical chart has been a tremendous aid in understanding the fundamentals of Stochastic behavior.  Let the author know if you enjoyed this article.  If so, the theoretical chart will be used in future articles to analyze the fundamental behavior of other studies and tools.

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