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Oscillators are widely used as a tool of technical analysis. They are popular mainly because of their leading signal generating ability, being as leading indicators they don’t lag behind the price action. They are most profitable in a sideways market, in contrast to trend following indicator like moving average, which is more profitable in a trending market.

Oscillators take the form of lines drawn below the price plot and usually move in a pre-defined range and they are often similar in structure. Oscillators are used for generating trading signals by using the direction and value of oscillators. The value of the oscillators indicates the strength of trend. If the value of oscillator rises, the price increases and it gains momentum. Oscillators are also used to find out the overbought and oversold zone, if the price rises too quickly the oscillator reaches to a level at which it is considered overbought. Conversely, if the prices decreases too sharply, the oscillator reaches to a level at which it is considered oversold.

As a general rule, 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. As another general rule, 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. We’ll see how these general rules are applied as we deal with the various types of oscillators.

There are three situations when the oscillator is most useful. You’ll see that these three situations are common to most types of oscillators that are used.

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 that 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.

1. Absolute price oscillator (APO), because it deals with the actual prices rather than percentage changes.

2. A percentage price oscillator (PPO), on the other hand, computes the difference between two prices.

3. A third member of the price oscillator family is the DE trended price oscillator (DPO), which ignores long term trends while emphasizing short term patterns.

While an APO will show greater levels for higher priced securities and smaller levels for lower priced securities, a PPO calculates changes relative to price. Subsequently, a PPO is preferred when: comparing oscillator values between different securities, especially those with substantially different prices; or comparing oscillator values for the same security at significantly different times, especially a security whose value has changed greatly.

References

[1] Profitability of Oscillators Used in Technical Analysis for Financial Market, Mohd Naved and Prabhat Srivastava, 2015

[2] John J. Murphy, Technical Analysis of the Financial Markets, New York Institute of Finance, 1999

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Ihab Salloum