How to Use Oscillators in Trading?

What Does an Oscillator Offer?

An oscillator provides the trader with various perspectives from which traders can analyse the price action of a security. While some, like moving averages, are easy to understand, others, like Stochastic, have rather complicated formulas. Irrespective of the complexities of the formulas, oscillators can offer a distinctive perspective on the strength and direction of the particular price action. 

Features of an Oscillator

There are multiple reasons one should know how to use an oscillator in trading. The primary reason is that it renders a clear picture of market action and predicts potential market moves. Furthermore, it is relatively easy to formulate and interpret. An important part of understanding how to use an oscillator in trading is to understand its key features. The following are some of the prominent features of an oscillator –  

1. Oscillator Interpretations 

Oscillators are developed with higher and lower boundaries along with display lines, moving back and forth between boundaries. Peaks and lows in an oscillator ideally correspond to the highs and lows of the market. 

2. Divergence 

When the market hits high, it becomes neutral and then eventually makes a higher high. However, the oscillator makes a high, gets to a neutral position and then gets to a lower high, indicating bearish divergence. Similarly, when the market is low and then gets to a lower low, the oscillators get to a low and then make a higher low; an indication of bullish divergence. This proves to a beneficial indicator that the existing trend is slowing or subsiding, and there will be an emergence of a new trend. 

3. Extreme Reading 

Extreme low or high readings suggest an oversold or overbought situation. However, in a staunch and trending market, the oscillators are likely to show extreme readings for a long duration. However, traders don’t have to sell a market in this condition as it may be just the start of a new trend. 

4. Midpoint Line Crossing 

When the oscillator passes through the midpoint line, a signal is provided that prices will move in the direction of crossing. If the line passes through the midpoint from the upside, then it shows bullish. If it crosses down through the midpoint, it is bearish. 

5. Overbought

Overbought indicates a specific time period that reflects a consistent upward trend in the market without the presence of much pullbacks. This market condition indicates a rise in the value of a stock.

6. Oversold

An oversold market condition specifically reflects a consistent downward trend in a particular asset’s price. That doesn’t confirm that the stock will perform badly in the market; there is always the possibility of improvement.

7. Buy Signal

When the oscillator passes above the zero lines, it indicates a buy signal. When the indicator crosses the zero line, it implies that the price of the security is reversing course by having bottomed out.

8. Sell Signal

When the oscillator crosses the zero line from below, it signifies a sell signal. When the indicator crosses the zero line below, it can imply two things. First, the security is reversing course by topping out.

9. Exit Signal

When the momentum is reversing course and is moving back to the zero lines, that means profit opportunities have been windswept. This is considered a good time to exit the market. The quicker the trader makes an exit, the less he/she loses in this situation. 

Why Use an Oscillator in Trading?

Prior to knowing how to use an oscillator in trading, you must first understand why to use it. The following are some of the reasons that make oscillators an important aspect of trading –

1. It Alerts

An oscillator acts as an alert to assess study price action more comprehensively. If momentum is waning, then it may be a signal for a break of support. Conversely, if there is a significant positive divergence formation, it may act as an alert to monitor for a resistance breakout.

2. It Confirms

Oscillators can be used to verify other technical analysis tools. If the price chart shows breakout, a corresponding moving average may serve to authenticate the breakout. If the asset breaks support, a corresponding low in the on-balance-volume could confirm the weakness.

3. It Predicts

Many trading experts believe that oscillators can be used to predict the future direction of prices.

Types of Oscillator

There are multiple types of oscillators. In order to know how to use oscillators in trading, it is important to understand the various types. Mentioned below are some popular oscillators. 

1. Momentum Oscillator 

The Momentum oscillator assesses the number of times a security’s price has fluctuated over a period of time. In a Momentum oscillator, the current price is divided by the price of the previous period, and the quotient derived is multiplied by 100. Furthermore, the result is an indicator move around 100. Values less than 100 signify negative momentum or decreasing price, whereas values more than 100 indicates positive momentum or increasing price. 

Formula: Price today/Price X period ago x 100

How Does the Momentum Oscillator Work?

• If the Momentum oscillator shows extreme low or high values, you can assume a continuation of an existing trend. 

• This oscillator form has no upper or lower boundary; therefore, you have to detect the history of the momentum line visually. Furthermore, you have to draw horizontal lines along the upper and lower boundaries. When the momentum hits this level, it may indicate that the security is overbought or oversold. 

• The Momentum oscillator is considered an emancipated oscillator, signifying that there are no upside or downside limits. This, in turn, makes construing oversold or overbought conditions biased. When the oscillator is overbought, the security can continue to move upwards. Similarly, when the indicator is oversold, the security can continue to move lower. Therefore, it is recommended to use Momentum oscillators along with other indicators in order to read market conditions. 

• If the particular security makes a new high or low, which is not verified by the indicator, this might be an indication of price reversal.

2. Rate of Change (ROC)

The Rate of Change (ROC) oscillator is also known as Momentum. It is one of the commonly used Momentum oscillators. Calculation of ROC measures the existing price of the security with the price of X period. The line is an indicator that passes the zero lines from above and below, with the ROC moving from a negative to a positive line. ROC also includes overbought and oversold trajectories that can be adjusted as per the market conditions. 

Formula 

ROC = [(Today’s closing price – Closing Price X periods ago)/Closing Price X periods ago] x100 

How the Rate of Change Works

• A growing surge indicates a sudden price movement. A descending force reflects an abrupt price decline. 
• Typically in Rate of Change, prices will continue to increase until the ROC is positive. Similarly, the prices tend to decrease when the ROC goes negative. 

• ROC becomes positive with advance acceleration, whereas it tends to move towards the negative zone as the decline accelerates. 

3. Moving Average Convergence/Divergence (MACD)

Moving Average Convergence/Divergence is an oscillator that is harnessed to trade trends. While it is primarily an oscillator, it is not entirely used to establish overbought or oversold conditions. It is shown in the charts as two lines that move without boundaries. The crossover of the two lines offers trading signals that resemble a two moving average system. 

Formula 

The MACD can be calculated by deducting the 26-period value of exponential moving average from 12 periods of EMA. The shorter EMA converges towards and diverges away from the longer EMA. This results from MACD to fluctuate around the zero levels. A signal line is generated with a 9-period EMA. 

How Does Moving Average Convergence/Divergence Work?

• MACD that crosses above zero is considered bullish, and when it crosses below, it is considered bearish. Moreover, when MACD moves up from below zero, it indicates a bullish condition. When it moves down from above zero, it reflects a bearish condition.

• When the MACD line moves above the signal line from below, it reflects bullish. The further below the zero lines, the stronger the signal. 

• When the MACD line cuts the signal line from above to below, the indicator reflects bearish. The further above the zero signal line, the stronger the signal.

• During trading ranges, the MACD will whipsaw. wherein the fast line moves back and forth across the signal line. Traders typically avoid trading in such conditions or close positions to mitigate volatility within the profile. 

• The divergence between the price action and MACD is considered a stronger signal when it verifies the crossover signals. 

4. Relative Strength Index (RSI)

Relative Strength Index measures the magnitude of average gain and losses of a particular security. This evaluation is performed to extend inference regarding the strength and weakness of the underlying security. Essentially, this oscillator is used to identify general trends, failure swings, divergences, line crossover, etc. 

Relative Strength Index – Formula 

RSI = 100 – (100/1+Relative Strength)

Relative strength is the average of x days up closes multiplied by an average of x days down closes. 

How Does Relative Strength Index Work?

• When RSI is below 30, it is considered oversold, whereas when it is above 70, it indicates overbought. 
• When the RSI ranges from 30 to 70, it indicates no trend. 
• When the RSI moves between 40 and 80 zones, it indicates bullish range. When it oscillates between 20 and 65, it reflects bearish ranges. 

5. Slow Stochastic 

The Slow Stochastic Oscillator determines the location of the close relative to the high-low range over a predetermined time period. The Stochastic indicator varies from 0 to 100. In cases of an uptrend, the closing price tends to close near the high, and it closes near the low in cases of a downtrend. Slow Stochastic is effective in wide trading ranges or slow-moving trends. 

Two lines are formed: the slow swinging %K and an oscillating average of %K, referred to as %D. 

Slow Stochastic Formula – 

Slow %K = 100 [Sum of the (C-14) for the %K Slowing Period/Sum of the (H14-L14) for the %K Slowing Period]

•     %K Slowing period = 3   
•     C = Latest Close
•     H14 = Highest high for the last 14 periods
•     L14 = Lowest low for the last 14 periods

How Slow Stochastic Works

• Typically, the area over 80 indicates an overbought range, whereas the area below 20 is referred to as the oversold region. When the oscillator goes over 80-level and goes below 80, it indicates a sell signal. Similarly, a buy signal is given when the oscillator is below 20 and then crosses back over 20. 
• When the two lines move through the overbought or oversold region, it results in the oversold region. When a decreasing %K line moves through the %D in the overbought region, it is a sell signal. 
• A bullish divergence occurs when price makes a lower low; however, the Stochastic oscillator creates a higher low. A bearish divergence is created when the price makes higher highs; however, the Stochastic oscillator creates a lower high. 

How to use Oscillators in Trading

An oscillator is essentially an ECG of the trading market. It indicates the market conditions and allows traders to take the necessary action in order to make well-informed decisions. There are many types of oscillators, such as MACD, RSI, Stochastics, etc. Each of these oscillators offers a unique perspective of the market; however, they eventually offer similar signals. The best way to know how to use an oscillator in trading is to understand it thoroughly. It is recommended not to rely on a single oscillator to draw a conclusion but to use a combination of oscillators that best suits your needs. Subsequent to that, learn them inside and out.

Rule 1 – Focus Only on Trend-Following Signals

A trend-following signal is the most basic and reliable signal that an oscillator offers. This is because it offers signals in both directions. So, the first rule when using an oscillator is only to follow the trend signal. In the case of an uptrend, a buy signal is when the oscillator moves lower in the range and makes a dip. The dip doesn’t always move down into the oversold zones, so the trick is to read the dips with regard to other analysis like the resistance of changes, support, etc. At times, in a strongly trending market, a dip may become very shallow and stay in the overbought and oversold region for a long time.

Rule 2 – Look Out for the False Breakouts in Case of Ranging Assets

Oscillators can be used while trading in ranging assets. It further makes it possible to use bullish as well as bearish signals. When the assets move upwards to the top of the range, the oscillators provide bullish signals until they hit resistance. It is a riskier technique because it tends to give more false signals. You can witness breaks above and below the range, so only trade when there is a firm confirmation.

Forex Oscillators

Forex oscillators reflect the moments when the foreign exchange market hits its limit in any direction. When a price moves upward to high, then the market is considered overbought. This implies that the price will remain stable or slide down because traders are willing to fix their gains. Furthermore, during the negative correction, new traders will enter the market, which increases the price. Subsequently, the oversold market shows the opposite condition: when the price declines too much, a positive correlation is likely to occur.

Analysts suggest that it is stable to buy on the oversold market and sell when the market condition shows overbought. When the oscillator value moves towards the upper extreme, the security is deemed to be overbought, and when it draws near the lower extreme, it is considered to be oversold.

Oscillators are not merely used to determine overbought or oversold market conditions; they are also leveraged to predict breaking point in a price movement. Some of the breaking points are first-second order derivative, and on graphs, their lines and price lines move in the same direction. When the line begins to move apart, experts consider that the trend is losing steam in the market.

Analysis of Forex Oscillators

Analysis of forex oscillators entails two key elements – discovering if the forex market is in short-term oversold or overbought condition, and identification of dispersion with the price as the oscillator value approaches its extreme. Momentum and Rate of Change are the most common types of oscillators. These indicators assist traders in assessing whether an existing trend is acquiring momentum or strength or is losing it. In the latter stages of an uprising trend, the rate of price increases slows down. Such loss in momentum may not appear on the price graphs; however, it is visible on the supporting oscillator graph. Indicators that assess the Rate of Change and Momentum are highly essential components.

In cases where forex charts are not showing a definite trend in any direction, using oscillators can prove to be highly beneficial for the traders. In the trending market, an oscillator’s signals should be gauged with caution, considering that they are subject to providing false signals.

In the trading domain, traders measure oscillators on a percentage range of 0 to 100, where the closing price is related to the total price range for a particular number of bars in the concerned bar chart. To attain this, traders deploy numerous techniques manipulating and smoothing out various moving averages. When the market trades in a particular range, the oscillator follows the price fluctuations, reflecting an overbought condition when it moves above 70-80% of the particular price range, hence indicating a selling opportunity.

This signal remains valid until the price of the security remains in the formulated range, but when there is a price breakout, there might be certain false signals. Price breakout either suggests the rearrangement of the sideways market or inception of the new trend. Moreover, during this situation, the oscillator may remain in the oversold or overbought range for a long time period.

Oscillators are considered more suitable for a sideways market. They can be more beneficial when used in combination with a technical indicator that is capable of determining the market trend and range-bound situations.