Cashing in on Reverse Divergence

My fellow trader, Dr. David Paul, came to me with a new setup he wanted to trade. We tested it extensively, and it fulfilled the criteria we were looking for: good risk to reward, good hit ratio, good Sharpe ratio and all the other boring stuff that makes most people eyes glaze over.

In fact it proved to be a sizzling hot setup (which will be fully disclosed below), which we have traded and taught on our course over the last couple of years. So we decided to name it something as boring as Reverse Divergence just to disguise its true potential.

Now to the setup, which is a divergence setup between price and Stochastics (settings are the generic ones for any charting package, i.e. 14-3-3). We use it on the hourly and 4-hour chart, so it lends itself perfect to swing trading.

The rules are simple: you trade in the direction of the trend, as defined by some trend measure. It can be a 3-day high or low, or simply a 50 period Moving Average. The R D set-up happens when the Stochastics indicator has made a lower low, but price is making a higher low, in the direction of the trend.

In other words, the previous low on the price chart will correspond to a low on the Stochastics indicator. The next low will have to be higher low on the price chart, while at the same time Stochastics will have to take out the previous low.

The chart below will demonstrate the principle perfectly. Price is making a “higher low”, while the indicator is making a “lower low”.

Our entry comes by using a 4-bar fractal reversal. I will have to discuss that setup in the next instalment. Now you get the setup, and next time I will teach you the entry method.

Happy Trading

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