Using Oscillators

A very effective way to determine whether a market is overbought or oversold is to use an Oscillator indicator. These indicators show us when a market has become extreme (gone too far in one direction). When this happens, the market will generally correct itself by pausing and going sideways, or even going in the opposite direction of its existing trend.

Oscillators also indicate a divergence, usually before it actually occurs, during the extreme price activity. A divergence is when two lines that normally trend in the same direction, start to separate, or diverge, from each other. When this happens, often it is an indication that a trend is losing momentum.

From a price chart, we are able to see whether a price is rising or falling. Oscillators tell us more about the momentum, or pace, of a market and can give us a rate of change value at which the market is rising or falling. This is the most basic type of oscillator indicator.

An oscillator indicator will compare the latest closing price to a price in the past (this is a variable). When the latest price is higher, the value returned will be positive, and conversely, if it is lower, then the value returned will be negative. The oscillator fluctuates above and below a midpoint called the zero line. When it crosses above, it is considered to be positive and below is negative.

There are many other oscillator indicators that base their calculations on momentum and rate of change, but are also based on precise preset values. One such indicator was developed by Welles Wilder and called the Relative Strength Index (RSI). This indicator gives the user upper and lower boundaries to help determine overbought and oversold markets.

Another type of oscillator is the stochastic, which was developed by George Lane. Stochastics refers to the location of a current price in relation to its range over a set period of time. The time period most often used is 14 days. Although it is similar to the RSI oscillator, the overbought and oversold boundaries are wider, which makes the stochastic oscillator more volatile. It also utilizes two lines instead of one with the slower line a moving average of the faster line.