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So far you have seen how well some indicators, such as moving averages, work in trending markets.
However, these indicators are not useful in trading ranges. What you could use instead are oscillators. These are said to be leading indicators, as opposed to lagging indicators, which is what moving averages are, as they tend to lag the trend.
Oscillators lead price action and can give warning of an impending change in price direction, especially when there is a divergence. We will look at divergence later.
Unlike moving averages, which are plotted on the charts, oscillators are plotted below the price chart.
Most oscillators look alike and are interpreted in a similar way. Oscillator indicators are bound within a range, usually between zero and 100. This range is divided into and upper and lower halves by a mid-point line (which is sometimes zero, depending on the formula used to construct the oscillator).
Remember that oscillators are secondary indicators and should not be used exclusively but should be supported by using other indicators as well. You should always look at prices on the chart first, and whether the overall trend supports the idea.
Uses of Oscillators
Loss of Momentum
Oscillators can be used to indicate loss of momentum in the price move (trend).
Determining Extremes
Oscillators are a good tool for determining overbought or oversold conditions and give us a warning that the price trend is overextended and vulnerable. An oscillator will fluctuate between these two extremes of overbought and oversold.
Why so? Because markets are essentially driven by psychological forces and investors’ emotions change from greed to fear, to hope, and to despair. This is what causes momentum indicators to oscillate from overbought to oversold conditions.
We can say that the market is overbought when the oscillator is at an extreme in the upper half of the range. Oversold is when the oscillator is in the lower extreme.
Divergence
We can use oscillators to spot any divergence from price direction. This is an important warning that the price trend could change. Divergence only applies when the market is overextended (overbought or oversold). When in an extreme position, and the oscillator is in the opposite direction from price direction, this is called divergence.
In the chart below we can see that even though prices are still rising, the oscillator here (RSI) is beginning to decline, causing a bearish (negative) divergence. This gives a warning that the trend could turn down.
When the oscillator starts to turn back up while the prices are still declining, this is bullish (positive) divergence.
Crossing the Mid-point (or Zero) Line
Another use of the oscillator is when it crosses the middle line (or zero line) which separates the upper and lower half of the range, and to use it as a buy or sell signal.
Look at the chart below at the first red line. We sell when the oscillator crosses below the mid-point and prices are in a downtrend. On the other hand, buy when the oscillator crosses the mid-point from below and moves above while prices are in an existing uptrend.
Summary
An oscillator cannot just by itself be used to make a decision to enter a trade. It is a secondary indicator. Price always rules and the underlying trend is more important.
Look for overextended conditions, as this is usually where the oscillator is most useful. Consequently, especially look for divergence in extreme conditions – for example, prices going up and making new highs but oscillator turning down. Then also look for a mid-point or zero line crossing, as it may be a signal to buy or sell. Buy when above the line and sell when below.
