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 sideways market, in contrast to trend following indicator like moving average which is more profitable in a trending 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 goes up too fast, the oscillator reaches a level where it is considered overbought. Conversely, if prices drop too low, the oscillator reaches a level where it is considered oversold.

General Rules of Interpretation

As a general rule, when the oscillator reaches an extreme value at the high or low end of the band, this suggests that the current price move may have gone too fast and is due to a correction or consolidation of some kind. As another rule of thumb, the trader should buy when the oscillator line is at the low end of the band and sell at the high end. The midpoint line crossover is often used to generate buy and sell signals. We will see how these general rules apply when 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 high or low end of its limits. The market is said to be overbought when it is near the top and oversold when it is near the bottom. 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 Rating

1. Absolute Price Oscillator (APO), because it deals with actual 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 price oscillator family 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 lower tiers for lower priced securities, a PPO calculates changes relative to price. Subsequently, a PPO is preferred when: comparing oscillator values ​​between different securities, especially those with substantially different prices; or compare 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 oscillators used in technical analysis for the financial market, Mohd Naved and Prabhat Srivastava, 2015

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