Oscillator- A Secondary Indicator

The oscillator is extremely useful in nontrending markets where prices fluctuate in a horizontal price band, or trading range, creating a market situation where most trend-following systems simply don’t work that well. The oscillator provides the technical trader with a tool that can enable him or her to profit from these periodic sideways and trendless market environments.

The value of the oscillator is not limited to horizontal trading ranges, However, used in conjuction with price charts during trending phases, the oscillator becomes an extremely valuable ally by alerting the trader to short term market extremes, commonly referred to as overbought or oversold  conditions. The oscillator can also warn that a trend is losing momentum before that situation becomes evident in the price action itself. Oscillators can signal that a trend may be nearing completion by displaying certain divergences.

The oscillator is only a secondary indicator in the sense that it must be subordinated to basic trend analysis. We should also be aware that there are times when oscillators are more useful than at others. For example, near the beginning of important moves, oscillator analysis isn’t that helpful and can even be misleading. Toward the end of market moves, however, oscillators become extremely valuable.

Interpretation of Oscillators

Most oscillators look very much alike. They are plotted along the bottom of the price chart and resemble a flat horizontal band. The oscillator band is basically flat while prices may be trading up, down, or sideways. However, the peaks and troughs in the oscillator coincide with the peaks and troughs on the price chart. Some oscillators have a midpoint value that divides the horizontal range into two halves, an upper and a lower. Depending on the formula used, this midpoint line usually a zero line. Some oscillators also have upper and lower boundries ranging from 0 to 100.

Genreral Rules for Interpretation

1. When the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may have gone too far too fast and is due for a correction or consolidation of some type.

2. The trader should be buying when the oscillator line is in the lower end of the band and selling in the upper end. The crossing of the midpoint line is often used to generate buy and sell signals.

The three Most Important Uses for the Oscillator

There are three situations when the oscillator is most useful.

1. The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its boundaries. The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. This warns taht the price trend is overextended and vulnerable.

2. A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.

3. The crossing of the zero(or midpoint) line can give important trading signals in the direction of the price trend.

Measuring Momentum

The concept of momentum is the most basic application of oscillator analysis. Momentum measures the velocity of price changes as opposed to the actual price levels themselves. Market momentum is measured by continually taking price differencs for a fixed time interval. To construct a 10 day momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line. Any time period can be employed. A shorter time period (such as 5 days) produces a more sensitive line with more pronounced oscillations. A longer number of days (such as 40 days) results in a much smoother line in which the oscillator swings are less volatile.

Momentum Measures Rates of Ascent or Descent

By plotting price diffrences for a set period of time, we can study rates of ascent or descent. If prices are rising and the momentum line is above the zero line and rising, this means the uptrend is accelerating. If the up-slanting momentum line begins to flatten out, the rate of ascent has leveled off. When the momentum line begins to drop toward the zero line, the uptrend in price is still in force, but at a decelerating rate. The uptrend is losing momentum. When the momentum line moves below the zero line, a near term downtrend is in effect. As momentum continues to drop farther below the zero line, the downtrend gains momentum.

The momentum Line Leads the Price Action

The momentum line is always a step ahead of the price movement. It leads the advance or decline in prices, then levels off while the current price trend is still in effect. It then begins to move in the opposite direction as prices begin to level off. The trendlines on the momentum chart are broken sooner than those on the price chart. The value of the momentum indicator is that it turns sooner than the market itself, making it a leading indicator.

The Crossing of the Zero Line as a Trading Signal

A crossing above the zero line would be a buy signal, and a crossing below the zero line, a sell signal. It should be stressed that basic trend analysis is still the overriding considerastion.  Buy positions should only be takne on crossings above the zero line if the market trend is up. Short positions should be taken on crossing below the zero line only if the price trend is down.

The Need for an Upper and Lower Boundary

One problem with the momentum line is the absence of a fixed upper and lower boundary. One of the major values of oscillator analysis is being able to determine when marekts are in extreme areas. Through checking the back history fo the momentum line on the chart and drawing horizontal lines along its upper and lower boundaries, we can easily identify the outer extremities by  visual inspection.