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THE FINAL WARNING

After the first crossover occurs, stochastics are then set up to generate the third and final warning that the trend is over. This final warning is known as a divergence. There are two types of divergences. The first is bearish, which occurs after stochastics give their first crossover in overbought territory. Prices bottom and break to new highs, and fast enough so that stochastics do not have time to bottom and break to new highs as well (Figure 2). At this point, traders should scale further out of their long positions and avoid adding to that long position. The second type of divergence is bullish. This is simply the inverse of a bearish divergence.

But what if stochastics do break to new highs? If stochastics confirm the new high in price by setting a new high of their own, then chances are that, following the next market correction, at least one more high will be set by price. Figure 1 illustrates this perfectly. Each time the Eurodollar contract set new highs, stochastics did the same. Thus, even though the advance was overbought as per stochastics, new highs were probable until a bearish divergence was signaled. So in essence, if price and stochastics break to new highs together, it is bullish, no matter if the %D reading is above 80.

Now that you have been given three warnings that the trend is over, do you trade on the assumption that the market will reverse? No. Price action takes precedence over these stochastic signals.

Now that you have been given three warnings that the trend over, do you trade on the assumption that the market will reverse? No. Price action takes precedence over these stochastic signals. You must first do your homework, asking the same questions: Is there a reversal formation? Does volume confirm a reversal of trend? Does intermarket activity suggest that your market should reverse?

Figure 2 shows a perfect example of why you must wait for price action to confirm the stochastic signal. In the figure, a bearish divergence on the monthly stochastics is very clear. However, after prices tested the bottom of the channel, they resumed their uptrend despite the bearish divergence on stochastics. In this particular case, traders should have done one of two things: Either go long at channel supports, keeping trading size to a relative minimum; or remain flat altogether and wait for stochastics to turn, bullish again. The fact is, this bearish divergence never really amounts to anything until price action confirms it by breaking down out of the channel.

STOCASTICS SUMMARY

Above all, keep in mind that price action is most important of all. Stochastics are just a tool in a trader's toolbox, used to confirm or contradict trend analysis of price action. Until prices behave in a manner that is confirmed by a stochastic signal, the signal is nothing more than a warning. If the market trend runs contrary to a stochastic signal, then wait for stochastics to agree or trade a minimum size in the direction of the trend.

David Lundgren, 508-832-2002, publishes Trading Prophets, a daily faxed analysis of theВ  Treasury bond market.

ADDITIONAL READING

Murphy, John J. [1986]. Technical Analysis of the Futures Markets , New York Institute of Finance

FIGURE 1: WEEKLY EURODOLLAR FUTURES. Here, the slow 14-bar version of the stochastics indicator reached overbought levels early during each of the strong upmoves. The high readings of the stochastics indicator was a sign of strength.

FIGURE 2: T-BONDS MONTHLY. In September 1992, the Treasury bond market reached new highs while the stochastics indicator failed to make new highs. This signaled a possible reversal of the rally that began in 1990. However, the T-bond market needs to break the long-term uptrend line to confirm the warning from the stochastics indicator.