A technical analyst or trader using technical charts universally uses different kinds of indicators to interpret price movement and project future price actions. Among all indicators, the Oscillators or Oscillator indicators are special types of indicators.
Oscillators are an important part of technical analysis. Oscillators, as the name suggests, are those indicators that calculate two extreme values between which the asset price oscillates to and fro.
The two extreme values form two boundaries or bands, between which the asset price moves. The position of asset price within those extremes is calculated to determine the proximity of the price point to any of the extremes.
If the price goes near or crosses the upper extreme bands, it is considered to have reached an overbought position.
Similarly, when asset price goes near or crosses the lowermost extremes, it is considered to have reached the oversold position.
The technical analysts consider that asset price tends to always come close to its mean value whenever the price goes near or crosses any of the extreme points. Accordingly, they developed the oversold and overbought terms.
If an asset price goes to an overbought position, the price may come down and try to go near the mean value. Similarly, if the price comes down to the oversold position, the price may rise and come close to the mean value or cross it. This basic conception also helps the trader to be aware of forthcoming price reversals.
In this article, we will focus on different types of popular Oscillator indicators that traders use frequently.
How Do Oscillators Work?
Traders find Oscillators most effective when the market is not trending. In a trending market, be it an uptrend or a downtrend, price tends to move in one direction. Even if there are small oscillation movements, the price crosses the extreme points many times to move along with the trend. So we do not get effective Oscillator readings.
But in a trading market, popularly known as a rangebound market, Oscillators can catch price oscillation very effectively. In these situations, the price tends to move between two extremes. The Oscillators can plot price actions effectively and help traders to find future potential price movements and reversals.
An oscillator can be a leading or a lagging indicator. Some oscillators follow price action. And some oscillators lead the price action.
Most of the Oscillators effectively quantify price action on a percentage scale with respect to the mean value. These scales have readings like 0% to 100% from baseline or from the mean price. Every Oscillator has its own scale which should not be mixed up with the scale of another oscillator. We must judge Oscillator readings individually and see price movements of the stock on that scale only.
Let us discuss now how the different oscillators work and how to get maximum advantage from them.
Details of 11 Popular Oscillator Indicators You Should Read:
RSI ( Relative Strength Index)
RSI or the Relative Strength index helps us to identify the strength of the current trend. It is a popular momentum indicator or momentum oscillator.
J. Welles Wilder Jr. originally developed this indicator and introduced this indicator in his seminal 1978 book, “New Concepts in Technical Trading Systems.”
The name is slightly misleading as this oscillator does not compare two stocks, but rather helps us to understand the internal strength of a particular asset. (Probably a name like Internal Strength Index should be more apt).
Interpretation of RSI
When Welles Wilder first introduced this oscillator, he used a 14-day period. We are using it here. Later many other RSI periods found their use like a 9-day, 25-day RSI, etc. But the 14 days RSI is still a popular option. The period can be customized by the trader. A trader may customize it according to which suits his/ her trading style best.
RSI has a scale of 0 to 100. It is a price following or lagging indicator. When the RSI crosses or touches the 70% line, as seen in the upper portion of the RSI diagram, the stock price reaches the overbought condition. We can see the stock price falls after that.
Similarly when the RSI indicated crosses the 30% mark, the stock reaches the oversold condition. The stock price changes direction after that and rises from below.
But it must be mentioned that the overbought and oversold condition is not very accurate. A trader should not trade based on that reading without getting confirmation from other technical indicators. The RSI oscillator project approximates estimation, which remains a probability.
Traders prefer to modify RSI levels to suit their style and market conditions. It must be mentioned that during a continuing uptrend the RSI reading rarely comes below 30% and during a downtrend, the RSI rarely moves above 70%. Hence traders change levels accordingly.
Divergence in RSI
Divergence can be seen when RSI or the relative strength index readings do to agree with price movement. A bullish divergence occurs when the price chart makes lower lows, but the RSI indicator has higher lows. It is an indication that the price may go up.
Similarly, a bearish divergence occurs if the price goes up but the RSI indicator makes lower highs. It indicates that prices may go down in the future.
MACD is moving average convergence divergence. It is a lagging or trend-following momentum indicator. This oscillator draws a comparison between two moving averages of the stock. MACD is calculated by subtracting 26 periods’ exponential moving averages (EMA) from 12 periods of EMA.
The result obtained is the MACD line. Then a 9-day EMA of the MACD line is plotted over the MACD line, This line is known as the Signal line. The signal line is plotted over the MACD line to create the buy or sell signal.
Mostly MACD is represented by Histogram. It graphically represents the distance between the signal and the MACD line. We can see a baseline at the zero line. when the MACD line crosses the signal line, the histogram is above baseline and creates a buy signal.
Similarly, when the MACD line goes below the signal line, the histogram goes below the baseline, and a sell signal is created.
Traders spot this histogram for identifying the bullish or bearish momentum.
Traders use MACD crossover as an entry or exit signal. There is a bullish and bearish crossover.
When MACD crosses the signal line and goes above it and the histogram is above baseline, it is considered a buying opportunity.
Similarly, traders use bearish crossover. When the MACD line goes below the signal line and the histogram goes below baseline, a sell signal is generated.
Similar to RSI divergence when MACD histogram doesn’t agree with price action direction. We have bullish divergence and bearish divergence.
When the price is coming down by making lower lows but the MACD line is making higher lows and the histogram shows a bullish crossover, there is a chance that the price will start moving upwards.
During the bearish divergence, it is just the opposite. The price is going up by making higher highs but the MACD line is making lower highs and the histogram shows a bearish crossover.
The Stochastic oscillator is also a popular oscillator indicator. It is a leading indicator. The Stochastic oscillator compares a stock’s closing price with the price range of the stock over a time period. Its value varies from 0 to 100 measured and the stock prices move within this range. Traders find overbought and oversold zones through this indicator.
There are two lines in this oscillator, the %K and the %D. The %K is the mainline and %D is the moving average of %K. The stochastic oscillator also operates on a scale of 0 to 100.
Interpretation of Stochastic Oscillator
There are several ways to interpret this oscillator. The %K is calculated on a 14-period time span and the %D is a 3-period moving average of %K.
Whenever the stochastic crosses the 80% line, the stock is considered to be in the overbought zone. On the other hand, when the stochastic oscillator goes below the 20% line, the stock is in the oversold zone. But this signal is used to alert the trader, not as a trading signal. Traders use the crossover of these two lines as entry and exit prices if all other conditions prevail for those trades. Many traders prefer to choose their own ways of interpreting this oscillator.
Divergences in Stochastic Oscillator
The divergence of the stochastic oscillator is considered to be a good indicator for buy and sell entries. There is bullish divergence and bearish divergence.
In this chart of the Nifty 50 above we can see both the bearish and bullish divergences marked. We can see how the price behaved after the divergences found in the chart. After the bearish divergence occurred, the price fell. Similarly, when bullish divergence occurred, the price came out of the bearish trend and started rising.
It must be mentioned that price can stay in the overbought or oversold position for a prolonged period before starting to move the other way. Hence, a trader should keep in mind, that being in an oversold or overbought zone shouldn’t trigger any trade. A trader must need other confirmation for a trade.
Commodity Channel Index (CCI)
The Commodity Channel Index or CCI is a different kind of banded oscillator. The CCI measures the variation in the price of a stock from its statistical mean. The statistical mean is considered to be at zero level. It is a leading indicator.
The CCI compares the current price of a stock with the average price of the stock over a specific period. It was originally developed to find the current price trend in comparison to the long-term price average.
The CCI has multiple uses. It is not connected to commodity prices only as the name implies. The CCI can be used in several ways. This can be used as an oscillator because the price of stock oscillates around the center line. Unlike other oscillators, this oscillator does not provide the upper or lower limits. On the upside, it can be measured at +100 and more. Similarly, on the downside, it can go beyond -100 and less. Hence, it is unbound on extremes.
When the stock price move to +100 and beyond, we understand that the stock is in the overbought zone. On the other hand, when a bearish stock price action gives a reading of -100 and less, the stock is considered to be in the oversold zone. When the stock price hovers between +100 to -100, the stock is in not in a trading zone.
We can also find divergences in the price chart with the CCI. Traders manage their trades accordingly. The detailed discussion on the CCI is not within the scope of this article. Later we can discuss CCI in detail.
Awesome Oscillator (AO)
The Awesome Oscillator (AO) is somewhat similar to the CCI described earlier, but a lot of dissimilarities are also there. AO compares the last 5 candlesticks with the last 34 candlesticks in a candlestick chart. Then the value is calculated by the difference in their simple moving averages (SMA). The median price is the average of daily highs and lows.
The price action of the stock is measured on a scale that extends from 0 to both upwards and downwards with positive and negative integers at multiples of 50. There is no extreme value on both the upside and downside. The oscillator has also an unbound scale at the extremes like the CCI.
In this oscillator, the green bar indicates bullishness and the red bar indicates bearishness. AO is effective in all timeframes.
Traders can use zero-line crossovers for entry and exit. In addition, traders also use divergence for their trades.
The AO indicator gives good scalping opportunities when combined with indicators like the Bollinger Bands.
Price Rate of Change Indicator (ROC)
The ROC is another popular momentum oscillator. This oscillator compares the current price with the price some ‘n’ periods ago. This ‘n’ stands for any specific time period. The price is plotted against zero and the oscillator moves above zero into the positive territory when the stock price moves up and ROC moves below zero into negative territory when the stock price goes down.
Here is a standard, we have a 14-period ROC plotted below the Nifty 50 chart. Here the oscillator moves up to 30 when the stock goes up and ROC moves down to -30 when the stock moves below. The measurements on this scale could be different for other stocks.
Traders interpret the oscillator to identify trends and for reversals when the reading goes to maximum on both sides. Also, the highest readings do not stay there for long unlike other indicators, where overbought and oversold conditions are maintained for prolonged periods.
When the oscillator hovers around zero, traders interpret that a price consolidation is taking place.
ROC measures the strength of a trend. Also, traders use the crossover from zero line to positive or negative territory as hints for entry and exit prices.
The ROC is prone to whipsaws, particularly around the zero line. Traders should be aware of these false signals.
ROC is often used as a divergence indicator. Divergence occurs when the price and the oscillator move in opposite directions.
There is an inherent problem with ROC calculations. ROC gives equal weightage to price ‘n’ periods ago and the current price. Many technical indicators give more weightage to the current price than previous prices. ROC is good for divergence signals.
Money Flow Index (MFI)
Many analysts consider that big money flows into or out of a stock with big trading volumes. The Money Flow Index or MFI is based on this concept. The MFI uses volume and price data to come up with overbought and oversold signals. The MFI oscillator also moves between 0 to 100 like many other oscillators.
When the MFI index goes Similarly, when the MFI goes to 20 or below, the stock is said to be in an oversold zone. Though, traders often use 90 and 10 to be the threshold.
The Money Flow Index is popularly used to find divergence between stock price and the oscillator movement. The divergence signals from MFI are used as signals for potential price reversals.
Developed by Marc Chaikin, this oscillator uses the MACD line of accumulation – distribution. The Chaikin Oscillator is calculated by subtracting the 10 periods exponential moving average (EMA) of the accumulation distribution line from the 3 periods EMA of the accumulation distribution line.
Chikin Oscillator uses MACD of accumulation distribution data instead of closing price, This oscillator is used for identifying trends and reversals.
Because of MACD, the traders use this oscillator to spot the underlying momentum during price fluctuations. Because of the accumulation-distribution data being used, this technical indicator can identify whether the balance between buyers and sellers is tilted to one side.
This oscillator moves around a center line. The accumulation line goes above the center line to indicate a buying opportunity because the stock is being accumulated. The distribution line goes below the center line to indicate distribution. Traders interpret these signals and act accordingly.
Traders also make good use of divergence signals from this oscillator. A positive divergence is equivalent to bullish divergence and indicative of stock accumulation. A negative divergence indicates distribution.
Detrended Price Oscillator
The Detrended Price oscillator is not like other oscillators. It is not a momentum indicator. Rather it identifies the historical price peaks and troughs. The DPO identifies the asset price cycle. As the name implies, this oscillator eliminates the price trends. The absence of price trends helps to identify overbought and oversold levels more easily.
A long-term cycle is composed of many short-term cycles. Identifying these short-term components of long-term cycles helps to identify important turning points in the price cycle.
The DPO removes the long-term cycles. Once the trader specifies the time period, all longer-term cycles are eliminated leaving the specified time and short-term cycles within that time.
See in this chart, how the peaks and troughs the identified in the specified periods.
A trader can take advantage of this price cycle. The stock is bottoming every 1.5 to 2 months and peaking at 1 to 1.5 months. After identifying this cyclic order, the trader may want to enter the stock or exit from the stock at these troughs and peaks.
STIX is a short-term oscillator. It compares the volume flowing into advancing and declining stocks. This can be calculated over a sector or a particular group of stocks. By default, it provides an outlook on how the index or a range of stocks perform overall.
The STIX oscillator moves around the 50 levels. Usually, STIX oscillates between +42 to +58. When this oscillator goes below 50, it means the declining stocks are more. If STIX shows a reading below +42, it means the market is in an extreme oversold condition. Similarly, if this short-term oscillator moves above 50, it shows there are more advancing stocks. If the oscillator goes above +58, the market is considered to be in an extremely overbought condition.
Commonly STIX is not available on most of the charting platforms. In that case, a trader may calculate it manually. Traders find a reversal in STIX after the index stays long in the oversold or overbought condition.
Williams %R is a short form of Williams Percent Range is a momentum indicator. The reading oscillates on an inverted scale from 0 to -100. We find the oversold or overbought condition on this scale.
This indicator compares the stock’s closing price with the high-low ranges over a specified time, commonly 14 periods. This indicator is similar to the stochastic indicator and is used in the same way.
This oscillator may be used to find entry and exit levels. In this oscillator, -20 is the overbought zone and -80 is the oversold zone.
The stock price usually continues to rise or fall for some time after the indicator shows an oversold or overbought condition. Therefore, traders do not use these readings for trade. Rather the trade entries are made when the indicator is just coming out of the oversold or overbought territory.
Mentioned above are some of the popular oscillators used by traders during technical analysis. This article has tried to bring light on them and give an overall outlook on those oscillators. But detailed discussions on them were not done. Detailed studies will be given on individual oscillators later.