Category: Oscillators

The Awesome Oscillator (AO) was created by the famous trader Bill Williams to measure the difference between the latest 5 periods Simple Moving Average (SMA) and 34 periods SMA. It is plotted as a histogram, like the MACD. Simply put, when the histogram is above the zero line and increasing, it signals that bullish momentum is increasing. When the histogram is below the 0 line and decreasing, it signals that bearish momentum is increasing.

Most traders use the AO zero line crossover when the histogram goes above or below the 0 line from the other side, as a signal for change in predominant trend. But if you use the AO as a standalone indicator this way, you will likely find many false signals. The best way to use the AO indicator is called the Twin Peak strategy, which is a fancy term that basically describes trading divergence.

The important thing to remember that bearish Twin Peaks occur above the 0 line and bullish Twin Peaks occur below it.

The first three oscillators we discussed all use line charts to represent the reading. But the Moving Average Convergence Divergence (MACD) indicator is a completely different beast as it combines two Moving Average Crossover with Histogram to gauge the strength of the momentum.

The two lines of the MACD represent a 12-period EMA and a 26-period Exponential Moving Average (EMA). When the shorter period EMA crosses the longer period EMA, it signals a change in trend, just like a typical MA crossover. But, what makes MACD truly standout is the histogram that measures the distance between these two EMAs. When the histogram is above the 0 line and increasing, it signals an uptrend that is gaining momentum. On the other hand, when the histogram is below the 0 line, it signifies that the downtrend is gathering strength.

Unlike the Stochastics, RSI, or CCI, there are no predetermined overbought or oversold levels in the MACD oscillator. However, the trick is to compare the highs and lows in MACD to price action in relation to previous high and lows. In doing so, you can easily find convergence and divergence.

The Commodity Channel Index (CCI) has the look and feel of the RSI indicator. But, the underlying mathematical formula, as well as the application is completely different.

While the RSI oscillates between 0 and 100, the CCI has no upper or lower limit.

Instead, the indicator, under normal market conditions, fluctuates between -100 and +100 levels. When it remains within this normal range, it signifies that there is a lack of a strong trend in the market and signals that the asset price will likely remain range-bound.

By contrast, a reading above +100 indicates a strong uptrend and when it goes below the -100 level, it signals a strong downtrend.

Just like the Stochastics, the Relative Strength Index (RSI) oscillates between the 0 and 100 values. However, the overbought and oversold level are usually set at 70 during an uptrend and 30 during a downtrend. Besides this, the way to interpret the Stochastics is almost identical to the Stochastics indicator.

While both Stochastics and RSI are considered to be momentum oscillators, the RSI works best during a trending market as a reading above 50 signals an overall uptrend and vice-versa.

The trick with the RSI is to look for potential support and resistance level first and then finding market entry opportunities. To do so, instead of focusing on level 50, we can draw two additional lines, 40 and 60 on the RSI window.

The Stochastics indicator measures the relationship between an asset’s closing price and its price range during a particular period since the closing price of the asset would likely stay at the higher end of a day’s range during an uptrend.

Similarly, it would be near the low during a downtrend.

Keeping this principle in mind, the Stochastics indicator measures if the asset price has been trending, losing momentum, or simply trading in a range.

Any experienced trader can figure out a market’s directional movement just by looking at a chart. However, the Stochastics oscillator makes it much easier to interpret the price action.

The Stochastics oscillates between two fixed values, 0 and 100.

When it trades above the 80 level, some traders believe that it indicates that the bullish trend is likely to lose momentum. However, a look into the Stochastic formula confirms that a high Stochastic shows, in fact, a likely continuation.

So, the best way to find a market entry with the Stochastics indicator is looking for long entries after a temporary bearish retracement during an uptrend and a short entry after a bullish retracement during a downtrend. It may sound too complicated at first. Especially, if you are new to technical analysis and have little experience with trading divergences. But let’s take a look at an example and you will realize it is a rather straightforward concept to grasp.

The relative strength index (RSI) is a popular oscillator that measures the extent of recent price changes to determine overbought or oversold conditions in an instruments price. J. Welles Wilder Jr. developed the RSI and first shared it with the technical community in his book “New Concepts in Technical Trading Systems.”¹ It has become one of the most trusted indicators for anyone planning to use oscillators to determine buy and sell points.

In the example below, you can see Microsoft Corporation’s (MSFT) lower range of the relative strength index (RSI) is 30 and the upper range is 70. The mid-range is 50. The consensus amongst technical analysts is that the RSI becomes oversold at the 30 level and overbought at the 70 level.²

These levels are not set in stone, rather they are commonly used levels to gauge a stock’s overbought / oversold levels. Some charts and theories would use 20/80 as the low/high boundary. For some technicians, these numbers may be far too conservative, causing the trader to be too late on the buy-side and therefore miss out on capital gains. Also, if traders use the 80 high mark, they may miss the true selling point on the overbought side.

Arrows are shown at the entry points at which the RSI bounces off the 30 level. By drawing a horizontal channel between the $66 and $72 price levels, we have marked the horizontal trading pattern. Notice that the RSI tends to remain well above 50 while the price action is inside this horizontal channel. Here the RSI shows a somewhat overbought situation, but no major selling pressure is evident. Many investors believe Microsoft can be purchased at any level because they will hold it in their portfolios for the long-term and are not concerned with trading it short-term.

In technical analysis, an investor measures oscillators on a percentage scale from 0 to 100, where the closing price is relative to the total price range for a specified number of bars in a given bar chart. In order to achieve this, one deploys various techniques of manipulating and smoothing out multiple moving averages. When the market trades in a specific range, the oscillator follows the price fluctuations and indicates an overbought condition when it exceeds 70 to 80% of the specified total price range, signifying a sell opportunity. An oversold condition exists when the oscillator falls below 30 to 20%, which signifies a buy opportunity.

The signals remain valid as long as the price of the underlying security remains in the established range. However, when a price breakout occurs, the signals may be misleading. Analysts consider a price breakout either the resetting of the range by which the current sideways market is bound or the beginning of a new trend. During the price breakout, the oscillator may remain in the overbought or oversold range for an extended period of time.

Technical analysts consider oscillators better suited for sideways markets and consider them more effective when used in conjunction with a technical indicator that identifies the market as being in a trend or range-bound. For example, a moving average crossover indicator can be used to determine if a market is, or is not, in a trend. Once the analysts determine that the market is not in a trend, the signals of an oscillator become much more useful and effective.

Oscillators are typically used in conjunction with other technical analysis indicators to make trading decisions. Analysts find oscillators most advantageous when they cannot find a clear trend in a company’s stock price easily, for example when a stock trades horizontally or sideways. The most common oscillators are the stochastic oscillator, relative strength (RSI), rate of change (ROC), and money flow (MFI). In technical analysis, investors find oscillators to be one of the most important technical tools to understand, but there are also other technical tools that analysts find helpful in enhancing their trading, such as chart reading skills and the technical indicators.

If an investor uses an oscillator, they first pick two values; then, placing the tool between the two, the oscillator oscillates, creating a trend indicator. Investors then use the trend indicator to read current market conditions for that particular asset. When the investor sees that the oscillator moves toward the higher value, the investor reads the asset as overbought. In the opposite scenario, when the oscillator trends towards the lower value, the investors consider the asset oversold.

An oscillator is a technical analysis tool that constructs high and low bands between two extreme values, and then builds a trend indicator that fluctuates within these bounds. Traders use the trend indicator to discover short-term overbought or oversold conditions. When the value of the oscillator approaches the upper extreme value, technical analysts interpret that information to mean that the asset is overbought, and as it approaches the lower extreme, technicians consider the asset to be oversold.

KEY TAKEAWAYS

• Oscillators are momentum indicators used in technical analysis, whose fluctuations are bounded by some upper and lower band.
• When oscillator values approach these bands, they provide overbought or oversold signals to traders.
• Oscillators are often combined with moving average indicators to signal trend breakouts or reversals.