What are oscillators and how can be used in trading

Oscillators work under the premise that as momentum begins to slow, fewer buyers (if in an uptrend) or fewer sellers (if in a downtrend) are willing to trade at the current price. A change in momentum is often a signal that the current trend is weakening. Let’s take a look at a couple of examples of oscillators and how to use oscillators correctly.

What are Oscillators

Oscillators are a class of technical indicators that measure momentum by comparing the current price to the price range over a given period. These are useful in range-bound markets because that’s when price highs and lows for a given period provide meaningful support/resistance and thus are indicators that a reversal is more likely when price approaches these limits.

The figure above is an example of a daily EURUSD chart with three of the more popular types of oscillators, Moving Average Convergence/Divergence (MACD) on top, Relative Strength Index (RSI) in the middle, and Stochastic Oscillator on the bottom.

As their name implies, they oscillate between extreme levels or around a center line. Extremely low readings indicate an exceptionally low price for a given period and theoretically oversold condition. Extreme high readings suggest the opposite. Again, this information is very useful in range-bound markets, but meaningless in strongly trending markets, when the highs and lows that the oscillators depict are obsolete.

There are many oscillators, and there is plenty of good material on their theory and use online if you just enter their names into your search engine of choice. Because our focus is more on providing material on the practice and theory of profiting from forex trading that you can’t easily find elsewhere, and because so many of the oscillators are similar, we’re going to keep this article brief and recommend that you do some further study of these oscillators so that you understand how they work, and include at least one of them as part of your usual toolbox of four to seven forex indicators.

Regarding the oscillators shown in the Figure above:

  • MACD: This one deserves a bit more explanation. Assuming the following standard settings, the histogram shows the difference between a 12-period Exponential Moving Average (EMA) and a 26-period EMA. Its length and direction show the strength of the bullish or bearish momentum. The signal line is a 9-period Simple Moving Average (SMA) that serves as a trend change signal. 
  • RSI and Stochastic: Both are variations on the basic idea of comparing the current price to the price range over a given period. 

How Oscillators Generate Buy/Sell Signals

Oscillators generate buy/sell trading signals by showing:

  • Crossovers: Crossing extreme overbought or oversold levels. With oscillators that use multiple lines such as MACD and stochastics, the crossing of those lines can also generate a buy or sell signal.
  • Divergences: When oscillators move in the opposite direction from the trend, that divergence with the trend suggests price may soon change direction.

Oscillators Crossovers 

Crossovers occur when price crosses an indicator, or two indicator lines cross, for example:

  • Moving average crossovers: As we saw in the above Figure with MACD, one or more moving averages shown cross each other.
  • Oscillators cross extreme readings: If they show that price is high relative to prices over the period they cover, that suggests the asset may be overbought and due for a pullback. If they show that price is at the low end of the range for the period in question, that suggests the asset is oversold and is due for a bounce. For example:
    - The RSI can generate buy and sell signals when it goes beyond the 70 and 30 lines shown in Figure above and then reenters the middle zone between these lines, suggesting a reversal is coming.
    - The stochastic does the same when it exceeds either the 20 line or the 80 line as shown in Figure above and then reenters the middle zone between these lines. The crossing of the faster line over or under the slower line also suggests a change in trend momentum that can signal a coming bullish or bearish reversal.

When the MACD histogram crosses under the (usually red) signal line, that’s bearish, suggesting further reversal lower. When it crosses above the (usually red) signal line, that’s bullish, signaling possible reversal higher. Again, see Figure above for examples, with bullish and bearish crosses highlighted and labeled.

When Price and Oscillator Trends Diverge 

Momentum oscillators generally move in the same direction as price. However, because the momentum oscillators are measuring not just the direction of price change but also the rate of change in price, their direction will diverge from the direction of the price of the asset when the rate of change slows. In other words, when the price is moving higher or lower, so should the oscillator. However, when the speed of that trend slows, the direction of the momentum oscillators will start to diverge from that of price. Those divergences can be valuable leading indicators of a possible trend reversal. For example, slowing momentum, as reflected by these divergences, suggests a trend reversal may becoming. (See Figure below)

Here’s some explanation.

  • Lines A and A1: These are examples of how an oscillator typically moves in the same direction as price, in this case reflecting the same downward momentum.
  • Lines A and A2: Even though the USDCAD is moving lower, A2 shows how the stochastic oscillator is suggesting a reversal is coming, as it reflects increasing bullish momentum (or fading bearish momentum). In other words, recent prices have been higher over the period it measures, hence the uptrend in the stochastic that foretells the coming uptrend.
  • Lines B and B2: Again, while the USDCAD itself is moving higher, the momentum of the move is weakening over the dates covered; hence, while the pair itself keeps moving higher, the stochastic starts trending lower, forecasting the coming reversal.

When to Use Oscillators

We repeat: Oscillators are not that useful in strongly trending markets because prior highs or lows are not especially relevant. The perception of value is changing, hence the irrelevance of old highs and/or lows.

That said, in range-bound or gently trending markets they’re very useful in providing evidence of coming turns. The wider the trading range or channel, the lower the risk and the higher the potential yield. As we noted earlier when discussing channels, be wary of trading against the direction of the channel unless the channel is wide enough to allow you to profit even as time erodes your room to profit and pulls resistance closer each day.

Other Oscillators to Consider

There are many. First, do some more research on the ones we’ve mentioned. Not only are they as useful as any, they are also among the most popular and thus help you to understand what other traders are thinking and to anticipate their moves.

Here’s a partial list of other very popular oscillators you should certainly consider:

  • Commodity Channel Index (CCI): Despite its name, the CCI works equally well with forex and stocks, too, and provides both oversold/overbought as well as divergence indicators.
  • Rate of Change (ROC): This indicator measures the percent change from the price a given number of periods ago. It is useful as both divergence and an oversold/overbought indicator as it oscillates around a zero line.
  • Williams %R: Generates buy/sell signals via overbought/oversold, crossover, and divergences. It’s very similar to Stochastic %K, except that Williams %R is plotted a bit differently, using negative values ranging from 0 to –100. It’s the creation of Larry Williams, who, in addition to being a star commodities trader and investor, has published nine books on investing in forex and won the Robbins World Cup Championship of Futures Trading in 1987.

Understanding how to use oscillators correctly is important, but if you want some help, MetaTrader 5 AM Broker offers a useful Oscillators toolkit and our trainers can provide you the right guidance. Play around in a ​demo account and notice how oscillators can make you serious money. Alternative, use an Expert Advisor Builder and generate automated trading strategies using oscillators in a few clicks, without writing codes.

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