Using trading oscillators

Oscillators are technical analysis tools ideal for markets that are range-bound and trading sideways. They can also be interpreted as indicators that fluctuate above and below a centerline as the price of an underlying asset fluctuates from high to low and vice versa. The most popular oscillator indicators include a stochastic indicator and the Relative Strength Index.

Oscillators are normally used in conjunction with other indicators to make informed trading decisions. Technical analysts rely on oscillators to try and predict price movements when charts are not showing a definite trend in either direction.

I. Overbought and Oversold With Oscillators

Oscillators are also ideal for identifying overbought and oversold territories as part of price action analysis. Most trading oscillators are measured on a percentage scale of 0 to 100, fluctuating between the highs and lows depending on price movements.

An overbought situation occurs when an oscillator indicator exceeds the 70 level, signifying a potential sell signal. Conversely, whenever the indicator moves below the 30 level, the same is interpreted as oversold, signalling a potential buy opportunity. Oscillators can remain in overbought or oversold territories for a prolonged period; they cannot trend for a sustained period.

II. Types of Oscillators

While there are different types of oscillators, the two broad categories are centered oscillators that fluctuate above and below a center point and banded oscillators that fluctuate between overbought and oversold territories.

Centered Oscillators

They are best used in market situations where one needs to analyse the direction of price momentum. They are also ideal for identifying the strength or weakness of momentum. In most cases, a security would be considered bullish whenever the oscillator is trading above the centerline and bearish whenever the indicator moves below the centerline.

Banded oscillators

Banded oscillators, on the other hand, are ideal when one wishes to identify overbought and oversold territories.

III. Relative Strength Index

The Relative Strength Index is one of the most widely used banded oscillators that technical analysts deploy whenever a market is trading sideways with a lower range of 30 and upper range of 70. While below 30 and above 70 indicate oversold and overbought territories, some analysts consider those to be conservative measures, as they might cause a trader to enter late and miss out on capital gains.

In the chart above, it is clear that whenever the RSI indicator dropped below the 30 level, Microsoft’s price immediately bounced back and started moving higher. The arrows in the chart indicate buying opportunities in this case.

IV. Stochastic Oscillator

A stochastic oscillator is another effective banded oscillator for identifying overbought and oversold situations. For stochastic indicators, a reading above 80 is considered overbought, while a reading below 20 is considered oversold.

However, it is important to note that security prices don’t always adhere to overbought and oversold situations. In this case, the price may continue to move lower even in oversold territories as well as up even when entrenched deep in overbought levels, as indicated by a banded oscillator.

V. Bottom Line

Oscillators, when used with other indicators, can help a great deal in identifying buy and sell signals. These indicators are also ideal for identifying overbought and oversold territories that can signal a potential trend reversal.