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Beginner's Guide to TA

06 - Oscillators

Typography

The markets are said to trade within a range 70-80% of the time. Trends are the exception, and not the rule.

So what to do when the markets are flat?

The smart trader dons their range trading hat.

As a range trader, you are looking to enter near the top or bottom of a range, for a reversal back towards the opposite edge.

If the range persists, this can be done several times in a row before a trend breaks out.

Some of the best tools for this job include the Relative Strength Index (RSI) and stochastics.

Oscillators can be used for trading in trends too. For this we turn to the MACD. More on that later.

Picking tops and bottoms can be done… but it takes a few attempts

RSI and Stochastics be used to pick tops and bottoms.

While not typically recommended for most traders, picking tops and bottoms can be lucrative.

Generally you would wait for a combination of indicator signals, a strong chart pattern, and a key level.

If you do want to pick tops and bottoms, then you need have a thick skin. You will often be stopped out, and then, once you do get in on a reversal, you need to have the courage to hold on and not cut your profits short.

"Overbought" and "Oversold"

Indicators like RSI and Stochastics are designed to let the trader know if conditions are "overbought" or "oversold".

Overbought occurs when the price reaches "overvalued" levels and is primed for a pull-back. This may be because there are no new longs to continue the move, or existing longs start to take profits. The inference is that the high price can no longer sustain itself, so it must fall.

Oversold is the opposite. When the price has been pushed to low levels and is ready for a bounce, it is said to be oversold. In this case, the sellers have run out of steam, or are looking to take profit, causing the price to rise.

Be wary that just because an indicator says the price is overbought or oversold, it does not mean that a reversal will always occur. When the markets trend, a currency pair can stay overbought or oversold for a long time.

Another term commonly used for indicators that predict overbought and oversold conditions is "Oscillators", so named for their fluctuation around a central point, or between two numbers.

Divergence

One of the ways traders use these indictors is to spot "divergence" between the price and the indicator.

When the price makes a new high or low, and this is not supported by the indicator, it is a sign of an impending reversal.

This is perhaps best illustrated with a chart. On this cart of the GBPUSD, you can see the price made a new low, but the RSI did not.

Relative Strength Index (RSI)

One of the most popular oscillators in the Relative Strength Index (RSI).

It was developed by Welles Wilder, and was first published in 1978 in Futures Magazine. Its continued popularity speaks to its usefulness.

The RSI uses a calculation that measures price movement between the ranges of 0 to 100.

The price is said to be oversold when it is trading below 30 and overbought when it is trading above 70. NB: this does not have to be perfectly applied. Get to know the cadence of the pair you are trading and how it interacts with the indicator. You might find that a pair typically reverses after a reading of above 60 rather than 70 for example.

You can see the RSI here on the chart of the AUDUSD. In several cases the RSI printing near 30 or 70 coincides with the price changing direction.

You would look to combine a reading of below 30 with price action off a support level, or with a reversal pattern for a buy.

For a sell, you would be looking for a reading above 70 with price action off a resistance level or with a reversal pattern.

As well as looking to trade reversal patterns, RSI is commonly used to identify divergences. As mentioned above, a divergence occurs when the price makes a new high or low, and this is not confirmed by a similar high or low in the RSI.

Stochastics

The Stochastics Oscillator was developed by George Lane in the 1950's in order to track shifts in price momentum.

There are three types of stochastic indicator:

  • Fast
  • Slow
  • Standard

The standard version is the original developed by Lane. The fast version is used for very short-term price swings and can be a bit choppy. The slow version cut down on noise by smoothing out the oscillator.

Which one is right for you? Get very clear on your purpose for using the indicator in your plan, and then test which one does the best job. As a general rule, the slower the stochastics, the less signals it will generate, but the higher the quality.

Like the RSI, the Stochastics indicator oscillates in a range between 100 and 0. In this case, traders look for a read above 80 to indicate conditions are overbought and a read below 20 to indicate they are oversold.

Also similar to the RSI, you use stochastics to trade range bound conditions, or look for reversals in conjunction with chart patterns, candlesticks or key levels.

Here is an example on the EURJPY.

Here is an example of divergence between stochastics and price on USDCAD.

Another way traders use the stochastics, is to wait for either a cross of the two averages, or for the price to move back over the 20 or 80 lines before entering. This serves to ensure that they are not "trying to catch a falling knife". Wait for the momentum to shift back in your favour before entering.

MACD

The Moving Average Convergence Divergence indicator (or MACD as it is more commonly known) is perhaps a more flexible oscillator than the RSI or Stochastics.

The MACD measures, as the name implies, the convergence or divergence of two moving averages - a 12-day Exponential Moving Average (EMA) and a 26 day EMA.

The indicator has three main parts:

  • The MACD, which is the 12 day EMA less the 26 Day EMA
  • The signal line with is typically a 9 day EMA of the MACD
  • The MACD Histogram.

Sometimes the MACD is only plotted as a histogram without the MACD line.

The MACD can be used as to identify overbought and oversold conditions like the RSI or Stochastics, but is more commonly used to identify trends and for divergence studies.

When the MACD cross the Signal line, or the Histogram crosses over zero, then it is an indication of a change in the trend.

You can see here on the chart of NZDUSD how the cross of the MACD signals a new trend has broken out.

Here you can see a new high in the price of the EURGBP is not matched with a new high in the MACD, indicating divergence.

MACD can also be nicely combined with other oscillators to confirm signals.

Here we see divergence (twice) on the MACD, RSI reading above 70, and a bearish candlestick pattern combine prior to a downtrend in GBPUSD.

A final note

Oscillators are particularly useful tools for the trader.

The trick with using them is to make sure they serve a specific purpose in your trading. Be it helping you to time a reversal, or trade the range.

There is probably no need to use all three indicators at once. Pick the one that works best for you and the pairs you like to trade. Then learn it back to front.

Become a master in your indicator of choice, and eventually it will give you all the insight you need to generate winning trades.

Pepperstone
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