The oscillators are extremely useful in nontrending markets where prices fluctuate in a horizontal price band, or trading range, creating a market situation where most trend-following systems simply don’t work that well. The oscillators provides the technical trader with tool that can enable him or her to profit from these periodic sideways and trendless market environments.
The value of the oscillators are not limited to horizontal trading ranges, however. Used in conjunction with price charts during trending phases, the oscillators becomes an extremely valuable ally by alerting the trader to short term market extremes, commonly referred to as overbought or oversold conditions. The oscillator can also warn that a trend is losing momentum before that situation becomes evident in the price action itself. Oscillators can signal that a trend may be nearing completion by displaying certain divergences.
The oscillators are plotted along the bottom of the price chart and resemble a flat horizontal band. The oscillator band is basically flat while prices may be trending up and down or sideways. However the peaks and troughs in the oscillator coincide with the peaks and troughs on the price chart. Some oscillators have a midpoint value that divides the horizontal range into two halves, an upper and a lower. Depending on the formula used, this midpoint line is usually the zero line. Some oscillators also have upper and lower boundaries ranging 0 to 100.
As a general rule, when the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may have gone too far too fast and is due for a correction or consolidation of some type. As another general rule, the trader should be buying when the oscillator line is in the lower end of the band and selling in the upper end. The crossing of the midpoint line is often used to generate buy and sell signals. We’ll see how these general rules are applied as we deal with the various types of oscillators.
Three most important uses for the oscillators
1-The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its boundaries. The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. This warns that the price trend is overextended and vulnerable.
2-A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.
3-The crossing of the zero (or midpoint) line can give important trading signals in the direction of the price trend.
The Momentum Technical Indicator measures the amount that a security’s price has changed over a given time span. It is the most basic application of oscillator analysis. It measures the velocity of price changes as opposed to the actual price levels themselves. The formula for momentum is:
M = V – Vx
Where V is the latest closing price and Vx is the closing price x days ago.
There are basically two ways to use the Momentum indicator:
- You can use the Momentum indicator as a trend-following oscillator similar to the macd. Buy when the indicator bottoms and turns up and sell when the indicator peaks and turns down. You may want to plot a short-term moving average of the indicator to determine when it is bottoming or peaking.
If the Momentum indicator reaches extremely high or low values (relative to its historical values), you should assume a continuation of the current trend. For example, if the Momentum indicator reaches extremely high values and then turns down, you should assume prices will probably go still higher. In either case, only trade after prices confirm the signal generated by the indicator (e.g., if prices peak and turn down, wait for prices to begin to fall before selling).
- You can also use the Momentum indicator as a leading indicator. This method assumes that market tops are typically identified by a rapid price increase (when everyone expects prices to go higher) and that market bottoms typically end with rapid price declines (when everyone wants to get out). This is often the case, but it is also a broad generalization.
As a market peaks, the Momentum indicator will climb sharply and then fall off — diverging from the continued upward or sideways movement of the price. Similarly, at a market bottom, Momentum will drop sharply and then begin to climb well ahead of prices. Both of these situations result in divergences between the indicator and prices.
Momentum is calculated as a ratio of today’s price to the price several (N) periods ago.
Relative Strength Index (RSI)
The Relative Strength Index Technical Indicator (RSI) is a price-following oscillator that ranges between 0 and 100. When Wilder introduced the Relative Strength Index, he recommended using a 14-day RSI.. Since then, the 9-day and 25-day Relative Strength Index indicators have also gained popularity.
A popular method of analyzing the RSI is to look for a divergence in which the security is making a new high, but the RSI is failing to surpass its previous high. This divergence is an indication of an impending reversal. When the Relative Strength Index then turns down and falls below its most recent trough, it is said to have completed a "failure swing". The failure swing is considered a confirmation of the impending reversal.
Ways to use Relative Strength Index for chart analysis:
- Tops and bottoms
The Relative Strength Index usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart;
- Chart Formations
The RSI often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart;
- Failure swing ( Support or Resistance penetrations or breakouts)
This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough);
- Support and Resistance levels
The Relative Strength Index shows, sometimes more clearly than price themselves, levels of support and resistance.
As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative Strength Index. Prices usually correct and move in the direction of the RSI.
The Stochastic Oscillator Technical Indicator compares where a security’s price closed relative to its price range over a given time period. The Stochastic Oscillator is displayed as two lines. The main line is called %K. The second line, called %D, is a Moving Average of %K. The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line.
There are several ways to interpret a Stochastic Oscillator. Three popular methods include:
- Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises above that level. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level;
- Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line;
- Look for divergences. For instance: where prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.
Moving Average Convergence/Divergence (MACD)
Moving Average Convergence/Divergence (MACD) is the next trend-following dynamic indicator. It indicates the correlation between two price moving averages.
The Moving Average Convergence/Divergence (MACD) Technical Indicator is the difference between a 26-period and 12-period Exponential Moving Average (EMA). In order to clearly show buy/sell opportunities, a so-called signal line (9-period indicators` moving average) is plotted on the MACD chart.
The MACD proves most effective in wide-swinging trading markets. There are three popular ways to use the Moving Average Convergence/Divergence: crossovers, overbought/oversold conditions, and divergences.
The basic MACD trading rule is to sell when the MACD falls below its signal line. Similarly, a buy signal occurs when the Moving Average Convergence/Divergence rises above its signal line. It is also popular to buy/sell when the MACD goes above/below zero.
The MACD is also useful as an overbought/oversold indicator. When the shorter moving average pulls away dramatically from the longer moving average (i.e., the MACD rises), it is likely that the security price is overextending and will soon return to more realistic levels.
An indication that an end to the current trend may be near occurs when the MACD diverges from the security. A bullish divergence occurs when the Moving Average Convergence/Divergence indicator is making new highs while prices fail to reach new highs. A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows. Both of these divergences are most significant when they occur at relatively overbought/oversold levels.
Calculation of MACD
The MACD is calculated by subtracting the value of a 26-period exponential moving average from a 12-period exponential moving average. A 9-period dotted simple moving average of the MACD (the signal line) is then plotted on top of the MACD.