Oscillators are technical analysis tools used in the construction of low and high bands between two extreme values. This tool then creates trend indicators that oscillate within the bounds. Forex traders use trend indicators to identify short-term oversold or overbought conditions.
As such, oscillators can be termed as being momentum indicators that are used in technical analysis. Oscillators are also mostly joined with moving average indicators thus signaling trend reversals or breakouts.
How do oscillators work?
Oscillators are normally used alongside technical analysis tools to help make informed trading decisions. Analysts prefer using oscillators as they are advantageous when it comes to finding a company’s stock price’s clear trend. For example, if there’s a stock that’s trading sideways or horizontally, money flow (MFI), rate of change (ROC), relative strength (RSI), and stochastic oscillator can be used.
When using oscillators, investors choose two values. The tool is then placed between these two values and a trend indicator will be created. That trend indicator is what will be used to show the present market conditions of particular assets.
If the oscillator migrates towards a higher value, it is said that the asset is overbought. If the trend moves towards a lower value, then that asset is oversold.
Mechanism of oscillators
Oscillators, in technical analysis, are measured on a percentage scale of 0% – 100%. Here, the closing price is said to be relative to a specific no. of bars’ total price range. To achieve this, different techniques are deployed to smooth out and manipulate moving averages.
When the market is trading in a given range, oscillators follow price fluxes then indicate overbought conditions when exceeding 70% to 80% of the given price range. This signifies an opportunity to sell. On the other hand, oversold conditions are whereby oscillators fall under 30% to 20%. Oversold conditions signify buying opportunities.
As long as the principal security price stays in the established range, the signal is considered to be valid. However, signals tend to be misleading in price breakouts. According to analysts, price breakouts are either resetting ranges or the start of another trend. When there’s a price breakout, oscillators remain in an oversold or overbought range for a long time.
Three types of oscillators
1. Momentum Indicators:
These are graphic devices that showcase the rate at which an asset’s price is moving in a specific direction. They give traders information on how long a price movement is likely to continue moving in that trajectory.
Momentum indicators have the principle, once an asset has been traded, its price movement will reach maximum when new money or investors enter when a specific trade is at its peak. If new investment is low, there is the likelihood the price will reverse or flatten direction. This formula customarily determines momentum’s direction:
Momentum = existing price- preceding price
Positive results indicate positive momentums, likewise, negative results indicate negative momentums. This indicator is also used in conjunction with the ROC indicator.
This oscillator compares asset price to that asset price’s price range over some time. It is primarily represented by the %K symbol. Its formula is also as follows:
%K= (closing price – low range)/(high range – low range) x 100
Stochastic oscillators are of different types and are plotted as the slow and the fast line on a graph. Their oscillations are smoothed out per the simple moving averages. When analysts use stochastic, they are searching for crossovers that identify buy signals. They are also looking for divergence indicating lows, highs, and price reversals on that chart that show oversold or overbought conditions.
3. RSI (Relative Strength Index)
This analyses current price losses and gains and later compares them to current prices. This is done to determine if specific currency pairs are at fair values. RSI is planned on a scale of 0 to 100 having positions near the low and high ends of a scale indicating a specific market’s asset. It also signals if a specific market’s assets are in oversold or overbought conditions.
RSI has the following formula:
RS =average no. of sessions where prices ended high/average no. of sessions where prices ended low.
Oscillators are normally planned on histogram charts. They are also referred to as being “no-limit” or “centered” oscillators when trend lines move above and below the center line. They are also called “branded” oscillators when lines move in bands.