Oscillators serve many purposes but they are primarily designed to give a clearer picture of market action and anticipate potential market moves. They are relatively easy to construct and interpret.
One the pluses of oscillators is that they can be used regardless of whether prices are moving up, down or sideways. Many other technical tools have little or no value in a sideways market, for instance moving averages.
Oscillators are typically constructed with lower and upper boundaries and display lines that oscillate between these boundaries. Ideally, peaks and troughs in the oscillator correspond to peaks and troughs in the market.
Extreme high or low readings suggest an overbought or oversold condition. However, beware in a strongly trending market, oscillators can stay at extreme readings for a long time. Do not sell a market just because it has an extreme reading in its oscillator – this may be just the start of the trend.
When the market makes a high, corrects, and then makes a higher high, but the the oscillator makes a high, corrects and then makes a lower high, we have bearish divergence. The reverse is also true – low, correction and lower low but the oscillator makes a low, corrects and makes a higher low, we have bullish divergence. This can be a very good advanced warning that the current trend is running out of steam and the end of the trend is imminent.
Crossing of the Midpoint Line
When the oscillator crosses the midpoint line, a signal is given that prices will move in the direction of the crossing. If the line crosses up through the midpoint, it is bullish. If it cuts down through the midpoint, it is bearish. This is the simplest of all signals.
Charting the Oscillator
This is something we have developed and found it to be effective on all time frames, five minutes up to daily. When charting an oscillator we look for trends and patterns.
Trends need only two points but are much better with three or more. If you join two pivot points, be prepared for the line to be broken easily. Remember, the points on the line should be pivot points. (The oscillator moves down and up again to give a pivot point. The latest bar cannot give you a pivot point unless the next bar moves away from your line.)
Sometimes you will even see chart patterns such as triangles and wedges. Interpretation of these patterns is exactly the same as if they had appeared on the chart itself.
Our opinion is that the best signals oscillators can give are divergence and the break of a trend line.
Types of Oscillator
There are several different types of oscillators, all of which are based on the concept of momentum (or speed) of price movements:
- Rate of change
- Moving average oscillator (MACD)
- Relative strength index (RSI)
- Slow stochastic
One of the main characteristics of momentum indicators is that they lead price action.
Momentum oscillators illustrate the acceleration or deceleration of prices rather than actual price level itself. A momentum oscillator is designed to measure the markets speed or rate or change.
So, for 10-event momentum,
- MOM (10) = Current value of 10-event momentum
- Ct = Todays closing price (or current price)
- Ct-10 = Closing price 10 events ago
The resulting value is therefore expressed in ticks or pips or points, oscillating around the zero line.
For example a 10-day momentum oscillator gives the difference between the current days price and the closing price 10 days ago. Each momentum value is either positive or negative.
|Oscillator Direction||Description (for daily charts)|
|Rising||Prices rose by more (or declined by less) today than it did ‘n’ days ago|
|Flat||Prices rose (or declined) by the same amount today as it did ‘n’ days ago|
|Falling||Prices rose by less (or declined by more) today than it did ‘n’ days ago|
Rate of Change Oscillators
Rate of change (ROC) is simply momentum expressed as a fraction or percentage.
So, for a 10-event rate of change,
- ROC (10) = Current value of 10-event rate of change
- Ct = Today’s closing price (or current price)
- Ct-10 = Closing price 10 events ago
ROC is the ratio of the current closing price a certain number of days ago. The ROC value therefore provides the percentage change between, oscillating around a ‘one’ line (or sometimes 100 line).
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