Divergences can be considered one of the stronger signals when using the Stochastic indicator.

A divergence is a signal that a rally or contraction is losing steam. The last buyers or sellers are pushing the price one way while the majority of traders have stopped and are wary of a correction or retraction.

The anatomy of a divergence is presented through some examples:

Example 1: British Pound vs US Dollar (May 9th, 2006)

A Bullish Divergence in the GBP/USD is followed by a 130 pip rise in price.

When prices are making new lows but the Stochastic indicator is not dipping past its recent lows it is an indication that a bullish rally may be likely. In the British Pound vs US Dollar example, price set a new low but it was not associated with a higher measure of distribution on Stochastics. The indicator did not dip to the same low level in the indicator panel.

Example 2: The Euro vs Japanese Yen (May 5th, 2006)

A Bearish Divergence in EUR/JPY is followed by a 125 pip drop in price.

When price is making new highs but Stochastic is not matching its most recent highs there is an increased likelihood that a bearish divergence will follow.

A divergence is even stronger when there is a combination of a divergence with a dip below the 80 level, or a divergence and then a rise above the 20% level. This incorporates the Overbought/Oversold interpretation discussed on page 3.

Example 3: The Euro vs US Dollar (May 11th, 2006)

A Bullish Divergence in EUR/USD is followed by a 150 pip rise.

A Dollar rally is stalled on May 11th. Price sets a newer lows, but selling pressure seems to be drying up by the look of the Stochastic indicator. When a Euro rally starts (after 5:00) there is lots of buying as the pair's bulls take control of the market.

Example 4: US Dollar vs Japanese Yen (May 10th, 2006)

A Bullish Divergence in USD/JPY is followed by a 100 pip increase.

A final example of a bearish divergence using a fourth, different currency pair. It overlaps with example 3 because the same divergence is observed on a different pair.

On May 10th, between 5:00 and 17:00, the Yen sets new lows but Stochastic does not. Yen bulls give over control to Dollar bulls and the Dollar rallies.

One can make a case that the bullish divergence is followed by a bearish divergence the following day. The Dollar sets a higher high (5:00 on May 11th), but Stochastic sets a lower high. The bearish divergence signal is followed by a 120 pip fall.