Oscillators

What are Oscillators?

• An oscillator is an indicator that fluctuates above and below a center line or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but they cannot trend for a sustained period. In contrast, a security or a cumulative indicator like On-Balance-Volume (OBV) can trend as it continually increases or decreases in value over a sustained period of time.

• Oscillators are indicators that are used when viewing charts that are non-trending. Moving averages (MA) and trends are paramount when studying the direction of a stock. A technician will use oscillators when the charts are not showing a definite trend in either direction. Oscillators are thus most beneficial when a company's stock either is in a horizontal or sideways trading pattern, or has not been able to establish a definite trend in a choppy market.

Types of Oscillators - 

There are many different types of oscillators and some belong to more than one category. The breakdown of oscillator types begins with two types: centered oscillators which fluctuate above and below a center point or line, and banded oscillators which fluctuate between overbought and oversold extremes. Generally, centered oscillators are best suited for analyzing the direction of price momentum, while banded oscillators are best suited for identifying overbought and oversold levels.

Centered Oscillators

Centered oscillators fluctuate above and below a central point or line. These oscillators are good for identifying the strength or weakness, or direction, of momentum behind a security's move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line.

• MACD

MACD is unique in that it has lagging elements as well as leading elements. Moving averages are lagging indicators and would be classified as trend-following or lagging elements. However, by taking the differences in the moving averages, MACD incorporates aspects of momentum or leading elements. The difference between the moving averages represents the rate of change. By measuring the rate-of-change, MACD becomes a leading indicator, but still with a bit of lag. With the integration of both moving averages and rate-of-change, MACD has forged a unique spot among oscillators as both a lagging and a leading indicator.

• ROC

Rate-of-change (ROC) is a centered oscillator that also fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC Oscillator. When the indicator is above 0, the percentage price change is positive (bullish). When the indicator is below 0, the percentage price change is negative (bearish).

Banded Oscillators

Banded oscillators fluctuate above and below two bands that signify extreme price levels. The lower band represents oversold readings and the upper band represents overbought readings. These set bands are based on the oscillator and change little from security to security, allowing the users to easily identify overbought and oversold conditions. The Relative Strength Index (RSI) and the Stochastic Oscillator are two examples of banded oscillators.

Oscillator Signals

Oscillators generate buy and sell signals in various ways. Some signals are geared towards early entry, while others appear after the trend has begun. In addition to buy and sell signals, oscillators can signal that something is amiss with the current trend or that the current trend is about to change. Even though oscillators can generate their own signals, it is important to use these signals in conjunction with other aspects of technical analysis. Most oscillators are momentum indicators and only reflect one characteristic of a security's price action. Volume, price patterns and support/resistance levels should also be taken into consideration.

Positive and Negative Divergences

Divergence is a key concept behind many signals for oscillators as well as other indicators. Divergences can serve as a warning that the trend is about to change or set up a buy or sell signal. There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances.

Pros and Cons of Oscillator Signals

• Banded oscillators are best used to identify overbought and oversold conditions. However, overbought is not meant to act as a sell signal, and oversold is not meant to act as a buy signal. Overbought and oversold situations serve as an alert that conditions are reaching extreme levels and close attention should be paid to the price action and other indicators.

• To improve the robustness of oscillator signals, traders can look for multiple signals. The criteria for a buy or sell signal could depend on three separate yet confirming signals. A buy signal might be generated with an oversold reading, positive divergence and bullish moving average crossover. Conversely, a sell signal might be generated from a negative divergence, bearish moving average crossover and bearish centerline crossover.

• It is dangerous to trade an oscillator signal against the major trend of the market. In bull moves, it is best to look for buying opportunities through oversold signals, positive divergences, bullish moving average crossovers and bullish centerline crossovers. In bear moves, it is best to look for selling opportunities through overbought signals, negative divergences, bearish moving average crossovers and bearish centerline crossovers.

• Finally, oscillators are most effective when used in conjunction with pattern analysis, support/resistance identification, trend identification and other technical analysis tools. By being aware of the broader picture, oscillator signals can be put into context. It is important to identify the current trend or even to ascertain if the security is trending at all. Oscillator readings and signals can have different meaning in differing circumstances. By using other analysis techniques in conjunction with oscillator reading, the chances of success can be greatly enhanced.

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