Oscillators are widely used as a technical analysis tool, they are popular mainly due to their ability to generate leading signals, as they are leading indicators that do not lag behind price action. They are more profitable in a side market, in contrast to the trend-following indicator like the moving average, which is more profitable in a trend market.

Oscillators take the form of lines drawn below the price chart and generally move in a predefined range and often have a similar structure. Oscillators are used to generate trading signals using the direction and value of the oscillators. The value of the oscillators indicates the strength of the trend. If the value of the oscillator increases, the price increases and gains momentum. Oscillators are also used to find out the overbought and oversold zone, if the price rises too fast, the oscillator reaches a level where it is considered overbought. Conversely, if prices fall too sharply, the oscillator reaches a level where it is considered oversold.

General rules of interpretation

As a general rule of thumb, when the oscillator reaches an extreme value at the upper or lower end of the band, this suggests that the current price movement may have gone too fast and is due to a correction or consolidation of some kind. As another general rule of thumb, the trader should buy when the oscillator line is at the lower end of the band and sell at 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 apply as we deal with the different types of oscillators.

The three most important uses of the oscillator

There are three situations where the oscillator is most useful. You will 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 limits. The market is said to be overbought when it is near the high end and oversold when it is near the bottom end. 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 a major warning.

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

Oscillator classification

1. Absolute Price Oscillator (APO), because it deals with real prices rather than percentage changes.

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

3. A third member of the family of price oscillators is the DE trending price oscillator (DPO), which ignores long-term trends and emphasizes short-term patterns.

While an APO will show higher tiers for higher priced securities and smaller tiers for lower priced securities, a PPO calculates changes relative to price. Subsequently, a PPO is preferred when: comparing oscillator values ​​between different values, 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 a lot.

The most common oscillators are MACD, RSI, ROC, CCI.

References

[1] Profitability of the oscillators used in the technical analysis of the financial market, Mohd Naved and Prabhat Srivastava, 2015

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