An oscillator is a technical indicator that fluctuates above and below a centreline or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but, because they can only move within certain ranges, they cannot trend for a sustained period. In contrast, a security, a moving average or a cumulative indicator like On-Balance-Volume (OBV) can trend as it continually increases or decreases in value over a sustained period of time.
There are many different types of oscillators and some belong to more than one category. There are two main types: centered oscillators and banded oscillators. Generally, centered oscillators are best suited for analyzing the direction of price momentum, while banded oscillators are best suited for identifying overbought and oversold levels.
Centered oscillators fluctuate above and below a central point or line. These oscillators are good for identifying the strength, or direction, of momentum behind a security’s move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its centre line and negative (bearish) when the oscillator is trading below its centre line.
MACD is an example. MACD is unique in that it has lagging elements as well as leading elements. While the moving averages on which it is based are lagging indicators, and would be classified as trend-following, MACD also incorporates aspects of momentum or leading elements. Even though there is no range limit to MACD, extremely large readings are unlikely to last for long.
Rate-of-change (ROC) is another centered oscillator that fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. When the indicator is above 0, the percentage price change is positive (bullish). When the indicator is below 0, the percentage price change is negative (bearish). As with MACD, ROC is not bound by upper or lower limits. This is typical of most centered oscillators and can make it difficult to spot overbought and oversold conditions.
Banded oscillators, which fluctuate above and below two bands that signify extreme price levels, offer a better alternative to gauge extremes. The lower band represents oversold readings and the upper band represents overbought readings. Most banded oscillators fluctuate within set upper and lower limits, but the Commodity Channel Index (CCI) is an example of a banded oscillator that is not range bound. The set bands are based on the oscillator and change little from security to security, allowing the users to easily identify overbought and oversold conditions.
The Relative Strength Index (RSI) and the Stochastic Oscillator are two examples of banded oscillators. With RSI, the bands for overbought and oversold are usually set at 70 and 30 respectively. A reading greater than 70 would be considered overbought and a reading below 30 would be considered oversold. For the Stochastic Oscillator, a reading above 80 is overbought and a reading below 20 is oversold. Making adjustments to the bands is usually a judgment call that will reflect a trader’s preferences and the volatility of the security.
Two important points are worth noting here. First, the terms ‘overbought’ and oversold’ can be confusing. Just because an indicator might enter an overbought area it does not follow that price is about to fall. Banded oscillators can stay in these areas for long times in trending markets and so they are best used in trading ranges or with securities that are not trending. Therefore their use and interpretation depends on knowing if the market is trending or not Second, it should be noted that oscillators that are in the same group will both provide similar signals. Therefore, using two similar oscillators together does not increase the confidence with which you can draw any conclusion and you are better to choose one and to stick with it.
Oscillators generate buy and sell signals in various ways. Oscillators can also signal that something is amiss with the current trend or that the current trend is about to change. Even though oscillators can generate their own signals, it is important to use these signals in conjunction with other aspects of technical analysis. Most oscillators are momentum indicators and only reflect one characteristic of a security’s price action. Volume, price patterns and support/resistance levels should also be taken into consideration.
Divergence is a key concept behind many signals for oscillators. Divergences can serve as a warning that the trend is about to change or set up a buy or sell signal. A positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances.
Even though securities develop trends, they also fluctuate within those trends. If a stock is in a strong uptrend, buying when oscillators reach oversold conditions (and near support tests) will work much better than selling on overbought conditions. During a strong downtrend, selling when oscillators reach overbought conditions would work much better. If the path of least resistance is up (down), then acting on only bullish (bearish) signals would be in harmony with the trend. Attempts to trade against the trend carry added risks.
Centreline crossovers can also provide signals. As the name implies, centreline crossover signals apply mainly to centered oscillators that fluctuate above and below a centreline which is sometimes interpreted as a buy or sell signal. A buy signal would be generated with a cross above the centreline and a sell signal with a cross below the centreline. For MACD or ROC, a cross above or below zero would act as a signal. Movements above or below the centreline indicate that momentum has changed from either positive to negative or negative to positive.
When a centered momentum oscillator advances above its centreline, momentum turns positive and could be considered bullish. When a centered momentum oscillator declines below its centreline, momentum turns negative and could be considered bearish.
A centreline crossover can also be used as a confirmation signal to validate a previous signal or reinforce the current trend. If there were a positive divergence and bullish moving average crossover, then a subsequent advance above the centreline would confirm the previous buy signal. Failure of the oscillator to move above the centreline could be seen as a non-confirmation and act as an alert that something was amiss.
Chaikin Money Flow is an example of a centered oscillator that places importance on crosses above and below the centreline. Divergences, overbought levels and oversold levels are all secondary to the absolute level of the indicator. The direction of the oscillator’s movement is important, but needs to be placed in the context of the absolute level. The longer the oscillator is above zero, the more evidence of accumulation. The longer the oscillator is below zero, the more evidence of distribution. Hence, Chaikin Money Flow is considered to be bullish when the oscillator is trading above zero and bearish when trading below zero.
To improve the robustness of oscillator signals, traders can look for multiple signals. The criteria for a buy or sell signal could depend on up to three separate yet confirming signals. A buy signal might be generated with an oversold reading, positive divergence and bullish moving average crossover. Conversely, a sell signal might be generated from a negative divergence, bearish moving average crossover and bearish centreline crossover.
Oscillators are also most effective when used in conjunction with pattern analysis, support/resistance identification, trend identification and other technical analysis tools. By being aware of the broader picture, oscillator signals can be put into context. It is important to identify the current trend or even to ascertain if the security is trending at all. Oscillator readings and signals can have different meaning in differing circumstances. By using other analysis techniques in conjunction with oscillator reading, the chances of success can be greatly enhanced.