Oscillators – When should oscillators be used?

Oscillators fluctuate above or below a pre-determined level – this is either a centerline or a set of values, such as “30″ or “70″, or “20 or “80″.

Examples of oscillator indicators include Stochastics, MACD (Moving Average Convergence/Divergence) and RSI (Relative Strength Index).

For 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 oversold.

Although these are the recommended band settings, futures markets may not adhere to these ranges and might require fine-tuning. Making adjustments to the bands is usually a judgment call that will reflect a trader’s preferences, based on the volatility of the market under analysis.

Over-bought or over-sold conditions, respectively, can remain in overbought or oversold territory for extended periods, however eventually, such levels cannot be sustained indefinitely.

It is critical to know when to use oscillators for technical trading – a trader can be short an over-bought market for days or weeks and experience considerable equity draw-down, prior to the market turning in favor of the expected market direction.

Oscillators are most effective in indecisive markets. In a trending market, oscillators can be ineffective technical analysis indicators. For example, in a strong bear market, a market can remain oversold for weeks. The reverse is true in a bear market.

As indicated, oscillators are calibrated around center values or pre-determined absolute values. In either case, trading on one side or the other indicates overbought or oversold conditions. When overbought, traders look to enter new short positions or liquidate existing long positions. The opposite is true for oversold conditions – when oversold, traders seek to enter new long positions or liquidate existing short positions.

There are many different types of oscillators. An important thing to understand about oscillators is when to use them.

Centered Oscillators

Centered oscillators fluctuate above and below a central point or line. This point can be optimized to be calibrated to the time frame in which you are trading.

Oscillators can be useful for identifying the strength or weakness behind a future’s market move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line.

MACD (Moving Average Convergence Divergence) is a centered oscillator that fluctuates above and below zero. Typically, MACD is the difference between the 12-day exponential moving average and 26-day exponential moving average of a futures market. However, these values can be modified to optimize your futures trading program.

MACD is unique in that it has traits that both lag and lead price action. Moving averages tend to “lag” the market. However, by analyzing the combined differences in both moving averages that comprise the indicator, MACD incorporates a “leading” indicator component to the “lagging” component.

The difference between the moving averages represents the rate of change. Clearly, by integrating moving averages and rate-of-change, MACD creates a unique oscillator that is both a lagging and a leading indicator. In summary, MACD is an important technical indicator that should be reviewed by technical analysts.

The Relative Strength Index (RSI) is a commonly used technical analysis oscillator. See it in action below.

The below chart is a classic example of bearish divergence, using a daily chart of September Crude Oil Futures and an RSI overlay study.

Tecnical Analysis - Bearish Divergence In Crude Oil

Rate of Change (ROC)

Rate-of-change (ROC) is a centered oscillator that fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC Oscillator. 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).

Many, but not all, banded oscillators fluctuate within set upper and lower limits. The Relative Strength Index (RSI) is trades in a range bound by 0 and 100 and will never go higher than 100 nor lower than zero.

The Stochastic Oscillator is another oscillator with a set range and is bound by 100 and 0 as well. However, the Commodity Channel Index (CCI) is an example of a banded oscillator that is not range bound.

Overbought and Oversold Extremes

Banded oscillators are designed to identify overbought and oversold extremes. Since these oscillators fluctuate between extremes, they can be difficult to use in trending markets. Banded oscillators are best used in trading ranges or with markets that are not trending.

In a strong trend, oscillator signals against the direction of the underlying trend are less robust than those with the trend. The trend is your friend – do NOT fade the trade, even if the oscillator tells you to do so. If a market 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 are foolish.

In another post, I will identify were we feel oscillators are very powerful. They are used to identify divergence patters (bullish or bearish).