Scholastic Divergence One

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Scholastic Divergence Lesson One: The Rules Copyright 2006 Rob Booker. All rights reserved. No part of this publication may be sold or changed without the authors consent.

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PART ONE: INTRODUCTION AND SETUP Guiding Principles

1. Every trend must end. 2. There is money to be made in the corrective patterns that follow trends.

Prerequisite Knowledge Do not proceed with this ebook unless you understand how to draw trendlines. You can learn more about trendlines from the support and resistance lessons in the training. You will also need to understand that MACD and the Stochastic Oscillator. Chart Setup

1. If you use xtick for charting, you will need the Stochastic Divergence + SMA template. You can get it here:

http://www.robbooker.com/books/stochastic_divergence_MA.cht If you dont use xtick, or you want to know what youre looking at on that chart template, please move to the next step.

2. You need the Stochastic Oscillator, set to 9,3,3.

3. You need the MACD with Histogram, set to 12,26,9.

There will be moving averages on your chart if you use the template above. Ignore those moving averages for now. You can keep them on your charts, but you wont need them yet.

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PART TWO: THE BASICS OF DIVERGENCE divergence (d -vr j ns, d -) n.1: A 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.

I will outline two main categories of Divergence. I will call them:

Regular Divergence (RD) & Hidden Divergence (HD)

Regular Divergence is a counter trend signal. RD attempts to show that a trend may soon be coming to an end or at least to a pause with a slight retracement. Hidden Divergence is a trend confirming signal. HD attempts to show you that the pause or retracement of the trend may be nearing its end, and the trend may soon be ready to continue. There are bullish and bearish types of both Regular and Hidden Divergence. You can use pretty much any oscillator to show divergence, but some of the most popular are: MACD, Stochastics, RSI, CCI, and Momentum. I will be using the MACD Histogram in the examples. Before we continue, I would like to warn that upon first attempt to comprehend Divergences, it is possible that your brain may overheat, and blow your radiator or head gasket. I will try to make it as simple as possible, but dont say I didnt warn you. Figure 2.1 This is a photo of a lady whose head is going to explode. She did not take her time and learn divergence one step at a time. She now receives counseling and therapy to help her overcome Post-Divergence Stress Traumatic Syndrome.

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REGULAR-TYPE DIVERGENCE Bearish Regular Divergence: Bearish RD occurs in a uptrend and signals an end to the uptrend and a potential bearish correction. Below is an example.

Figure 2.2. This chart is showing regular style bearish divergence. In figure 2.2, you can see that we were in an uptrend by the higher highs in price that I highlighted with the rising red line. But hold on a minute! The MACD Histogram made lower highs. The direction of the indicator is Diverging from the direction of price! This is telling us that the up trend may be coming to an end soon, and we may see a bearish correction sometime in the near future. And that is exactly what happened on the right side of the chart.

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Bullish Regular Divergence: Bullish RD occurs in a downtrend and signals an end to the downtrend and a potential bullish correction. Below is an example.

Figure 2.3. This chart shows you regular style bullish divergence. In figure 2.3, you can see where I drew the red lines, price made lower lows, constituting the down trend. But the MACD Histogram made progressively higher lows. Whats up with that? you may be wondering. That, my friend, is Bullish Regular Divergence. It is a signal that the strength of the downtrend is waning. And as you see in the chart above, the trend is beginning to reverse. That wasnt so bad right? Pretty straight forward stuff. But it is Hidden Divergence that makes peoples brains melt down.

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HIDDEN DIVERGENCE Bullish Hidden Divergence: Bullish Hidden Divergence occurs in an uptrend, and signals a continuation of the trend. Below is an example.

Figure 2.4. This is an example of hidden bullish divergence. Here we have an uptrend. It is highlighted by the red line showing a series of higher lows. But the MACD Histogram stretched way down low and made a lower low. This is a bullish signal! It shows us that the trend took a little break, but it did not take much of a correction to make the MACDH to fall way down into oversold land. I like to think of the MACDH as a slingshot getting pulled extra far down in order to shoot price upward. Figure 2.5. This is NOT a slingshot. It is hidden bullish divergence.

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Bearish Hidden Divergence: Bearish Hidden Divergence occurs in a downtrend, and is a signal of continuation of that downtrend. Below is a chart example.

Figure 2.5. This is bearish hidden divergence. The downtrend is defined by the lower lows and lower highs. I highlighted the lower highs with the red line. But the other red line shows that the MACD Histogram is making higher highs! Price made a little tiny rally, but it made the MACD Histogram go on a rampage into overbought territory. This is Bearish Hidden Divergence. It is a signal that the trend will soon continue. And so it does on the right side of the chart. Ok, this is all fine and dandy, and it looks like divergence kind of works, but there is something missingright? Like trade entry signals, and stop loss placement, and profit targets. Divergence is NOT a system on its own. You need to set other rules to define when you will get in and out of a trade once you identify divergence. For trade entry you can use trendlines, Fibonacci retracements, indicator levels or turning points, moving average crossovers, or Dionne Warwick. For stops, I usually like to place them beyond a recent high or low. I also like to use a recent high or low for a profit target, or break even point. In a strong trend, I would tend towards having a recent high or low be my break even point, and let the trend carry me to more profit. In a market with less directional momentum, I would tend to take all the profit at the recent high or low.

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Quick Recap:

o Bullish Regular Divergence: Counter Trend Lower Lows in Price & Higher

Lows on Oscillator o Bearish Regular Divergence: Counter Trend Higher Highs in Price & Lower

Highs on Oscillator

o Bullish Hidden Divergence: Trend Continuation Higher Lows in Price & Lower Lows on Oscillator

o Bearish Hidden Divergence: Trend Continuation Lower Highs in Price &

Higher High on Oscillator

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PART THREE: DIVERGENCE CHEAT SHEET MACD is in lower pane of each chart. Price in top pane.

MACD making lower highs. Price making higher highs.

MACD makes higher lows. Price makes lower lows

Figure 3.1. Print this sheet and have it laminated. Take it into the shower with you every day (youre showering every day, right?) Memorize it. Learn it so well that you can spot divergence on charts, on the road, in nature, and in all living things.

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PART FOUR: PRACTICE IDENTIFYING DIVERGENCE Regular Bearish Divergence Heres how to make it easier to identify Regular Bearish Divergence: draw a trendline on the MACD first. You can draw the line on the histogram OR the MACD trigger lines. Either way is fine. When you look at the MACD, look for places where its making hills/mountains and the RIGHT side mountain is lower than the left side mountain. Do you see that below? Draw a trendline over the top of the MACD histogram mountains from the high mountain to the lower mountain. Mark the point in time where the trendline starts and ends. Then draw a trendline ABOVE price. Make sure you start and end your trendline on price at the same place where you started and ended your trendline on MACD.

Figure 4.1. Can you draw the trendline on this chart, on the MACD, where the histogram OR the lines make a higher peak on the left, and a lower peak on the right?

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Regular Bearish Divergence, continued. See below if you drew the trendline in a good spot on the MACD.

Now lets move on to the other type of regular divergence: Bullish.

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Regular Bullish Divergence Heres how to make it easier to identify regular bullish divergence: draw a trendline on the MACD first. You can draw the trendline on the histogram or the lines. When you look at the MACD, look for places where the MACD histogram is making valleys RIGHT side valley is less deep than the left side valley. Do you see that below? Draw a trendline underneath the the MACD histogram valleys from the deeper valley to the shallow valley. Mark the point in time where the trendline starts and ends. Then draw a trendline BELOW price. Make sure you start and end your trendline on price at the same place where you started and ended your trendline on MACD. Regular Bullish Divergence, continued

Figure 4.2. Can you spot the trendline on the MACD? If you are having trouble, think of the beach. Think of the right side of the chart as the shallow end of the beach, where the water is meeting the sand. The further you go to the left of the chart, the deeper into the ocean you would go. The further to the right you go, the more shallow. Thats what you are looking for.

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Regular Bullish Divergence, continued

Figure 4.3. Did you draw the line in a good place?

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More Divergence Practice In the next section, you should attempt to spot divergence on the MACD and price. This time, as you go through the examples, please draw a trendline on the MACD and also on the price. Here are two examples of what your charts should look like, using the examples above.

Figures 4.7-6. Trendlines on the price and on the MACD complete the picture of regular bearish divergence in the top example, and bullish in the bottom example.

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More Divergence Practice Print these charts and draw trendlines on the MACD first, and then on the price. There is NOT divergence in every example, so be careful!

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PART FIVE: DIVERGENCE ASSIGNMENTS Find at least 5 examples of divergence, on each of the following charts. Send a few of your charts back to Rob. You dont need to send all of them back to Rob.

1. GBP/USD, 15 minute, between the hours of 12pm EDT and 12am EDT. 2. GBP/USD, Daily chart.

3. USD/JPY, 15 minute, between the hours of 12pm EDT and 12am EDT.

4. USD/JPY, 30 minute, any time of day.

5. USD/CAD, 60 minute, any time of day.

6. USD/CHF, Weekly chart.

7. EUR/JPY, Daily chart.

8. GBP/JPY, 240 minute chart.

9. CAD/JPY, Daily chart.

10. Current divergence. For this exercise, its good enough for you to find one

example of current divergence that is just barely setting up right now. The first person to find a current example will be given a prize.

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PART SIX: THE STOCHASTIC OSCILLATOR Prepare to be introduced to the indicator that makes this system possible. The Stochastic Oscillator is made up of two lines. The lines are named %K and %D. %K is the faster of the two, and %D is a smoothed, slower version of %K. The Stochastic Oscillator is based on the relation of the recent close, to the high and low of the user defined number of periods. The standard settings are 14 (number of periods), 3(moving average of number of periods), 3(moving average of number of periods). We are going to use the settings 9,3,3 for our own system. There are generally two types of stochastics to choose from in most charting platforms: Fast and Slow. Lets start with the Fast Stochastics, as that is where the calculation begins. %K is the first step in the calculation. %K = 100 ( recent close lowest low in (x) periods / Highest high in (x) periods lowest low in (x) periods ) This will show you in % value where the recent close is in relation to the high and low of (x) periods. In the standard settings x = 14 For example: Take these numbers for the high and low in 14 periods, and the close of the 14th period. H = 1.8228 L= 1.8151 C= 1.8185 The Calculation would be 100 ((1.8185-1.8151)/1.8228-1.8151) = 44.16 %K = 44.16 That is the same thing as saying 1.8185 is 44.16% of the distance from 1.8151 to 1.8228. Ok, now that we have beaten %K to death, we can move on to the other elements of Stochastics.

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In the standard settings %D is a 3 period Simple Moving Average (SMA) of %K. It is generally said that %D is more important to watch than %K if you are looking for a value of the stochastic oscillator.

Figure 6.1. The Stoch in action. The Red line is %K The blue line is %D Again, these are the calculations for Fast Stochastics. The Fast version is on crack and I hardly ever use it. As you can see, its jumpy and hard to read. Now lets look at the Slow Stochastics. I use the slow version because it is smoother, and therefore easier to read and make sense of it. Slow %K is a 3 period SMA of Fast %K. As logic would have it, Slow %K is the same thing as Fast %D. Slow %D is then a 3 period SMA of Slow %K.

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Figure 6.2. Fast and slow stochastics. Fast Stochastic in the first (top) indicator window. Crack pipe not shown. Slow stochastic in the second (bottom) indicator window. Using Stochastics The main use for Stochastics is to get an overbought or oversold reading from it. A reading above 80 is considered overbought. A reading below 20 is considered oversold. These can be helpful pieces of the equation that lead to making a trade, but they are not the whole equation on their own. Prices can continue to rise for a long time after 80 is reached on stochastics, and prices can drop a long ways after stochastics has reached 20.

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Figure 6.3. Can you identify good entries for a sell trade? What about buy trades? The best sell signals are given when Stochastics breaks above 80, and starts to rollover. You can also wait for it to break back below 80. The best buy signals are given when Stochastics breaks below 20 and then starts to curl up. You can also wait for it to break back above 20.

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PART SEVEN:

Scholastic Divergence

We can now teach you the basics of the system. The divergence system is created from a combination of divergence and stochastics (or Scholastics for you funny people out there). It is not hard to use once you have learned the other concepts youve read about so far. This system can work at any time of the day, on any time frame chart. Thousands of test trades have been done on time frames ranging from 5 minute to weekly. It can work at 6:00pm Eastern Time as well as it can be used at 6:00am Eastern Time. If you work full time, you can trade from the 4 hour or daily charts. If you love short term trading, you can trade this even during the New York session. What you will need:

1. A clear understanding of trendlines. If trendlines confuse you, then go back and do the assignments again and ask me for help. To do Regular Scholastic Divergence, you are going to need to draw trendlines ABOVE rising price, and trendlines BELOW descending price.

2. An understanding of divergence. If you still are confused about divergence, then do not proceed. Back up and start over. You are only hurting yourself if you try to rush this.

3. An understanding of Stochastics. Overbought, oversold, blah blah. Its easy. Above 80 is overbought. Below 20 is oversold.

4. To know how to turn on your charting program and load the MACD and Stochastics.

5. Patience. 6. Having xtick for charting does help. There is a chart template in xtick that will

allow you to set up everything quickly. If you dont use xtick, its okay. People have tested this strategy on eSignal, Tradestation, Metatrader, and lots of other charting platforms.

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The Rules

1) Find regular divergence across at least 10 candles. This means that the trendline that you draw above or below the candles must stretch across at least 10 candles. If you are drawing divergence across fewer than 10 candles, then please switch your charts to a quicker time frame (like from daily to 4 Hour, or from 1 hour to 15 minute) and you will be able to see the divergence across at least 10 candles.

2) For a short (sell) trade, two separate high peaks with the Scholastic over 80 must

make up the first and last candles. You will recognize two separate high peaks in xtick by the dots above the candles. You can draw your trendline across any candles that are overbought you do NOT have to start the line at the first overbought candle and end it at the last. This means that there MUST be candles in between the two peaks that ARE NOT overbought.

3) For a long (buy) trade, two separate low dips with the Scholastic under 20 must

make up the first and last candles. You will recognize two separate low dips in xtick by the dots below the candles. You can draw your trendline across any candles that are oversold you do NOT have to start the line at the first oversold candle and end it at the last. This means that there MUST be candles in between the two valleys that ARE NOT oversold.

4) You are looking for regular divergence, so the MACD histogram or lines must

be divergent with price, showing a potential reversal.

5) For 15 min charts, it helps that price is also hitting one side of the New York or European box. If you dont know what a box is, then you need to find some help.

6) Enter a short trade when a candle closes below 80 on the Scholastic. This is a

sign that the divergence is ready to play out.

7) Enter a long trade when a candle closes above 20 on the Scholastic. This is a sign that the divergence is ready to play out.

8) Exit a buy trade when the Scholastic reaches the 80 mark and the candle that

caused it to go to 80 is closed.

9) Exit a sell trade when the Scholastic reaches the 20 mark and the candle that caused it to go to 20 is closed.

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Example #1

Figure 7.1. Regular Bearish Divergence.

Do you notice that I drew the dotted trendline above the top of the candles, but I did not start the trendline at the first overbought candle?

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Example #2

Figure 7.2. Regular bullish divergence.

Do you notice that I drew the dotted trendline below the candles? If I draw the line on the bottom side of the MACD, then the trendline for the candles MUST go below the candles.

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Example #3

Figure 7.3. Can you see it?

Can you draw the trendlines to spot the divergence? Has a trade already been opened? Closed?

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Example #4

Figure 7.4. Regular bullish divergence.

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Scholastic Practice

1. Find at least one current example of Scholastic Divergence on the 15 min chart, during the Asian session, and trade it for 10 pips.

2. Use the testing spreadsheet and practice trade the GBP/USD during the Asian

session. Take at least 20 trades and log the results.

3. Use the testing spreadsheet and practice trade the GBP/USD daily chart. Take at least 50 trades and log the results.

4. Use the testing spreadsheet and trade at least 200 trades historically using the 15

min chart for the GBP/USD and the USD/JPY in the Asian Session.

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SECTION EIGHT: CONCLUSION This system is far from complete there is more to come and I will teach you more about it in later lessons. But alone, just like you have now learned it, it is profitable. You can trade this system profitably if you now test it and follow the rules. This means that right now, you should open up a spreadsheet, or get out a pen and a piece of paper, and you should go back in time on your favorite currency pair and your favorite time frame, and you should move forward candle by candle and trade as if you were following the system. Test at least 200 trades. Record your results. Send them to me. I suggest you test the GBP/USD 1 hour chart, but you could try any currency pair and any time frame. Testing will help build your confidence in the system. You cant depend on my word that this system works. You need to prove it to yourself. I am excited for you to backtest divergence. Let me know what you learn!

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Scholastic Divergence One