The Use of Oscillators

The Use of Oscillators

A perennial problem in stock trading for beginners is to know when to enter or exit in a trending market or what is the best time to get in when the market is range bound. Timing the market is given more importance when a trader is learning his skills rather than  turning to a professional, which can be done easily with the help of online stock trading platforms provided by stock brokers in India.

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In a trending market there are opportunities to get in for a trained eye, but for a novice, he would find it difficult to jump in a runaway train. When the stock market pauses for rest, the trader would think it would come down and wait for the right moment to get in. But the right moment never announces itself Before, getting into market it is important for the trader to open demat account with best brokerage firm in India

The stock market trader needs the help of some indicators to ‘announce’ a high probability trade. Though there are many indicators in technical analysis, most in some way or the others are subjective and hence difficult to interpret. Further, replicating prices, some of these indicators show no sign of pausing or giving an entry or exit signal. In short they tend to move without any boundaries or limitations.

As humans we have been taught to operate in a bounded environment. Limits have been fixed for us to benchmark our performances. Like the marks we can score in our exams or the cut-off time that is required to qualify for the marathon or the maximum pay hike that is possible based on your performance. This makes us relate to signals which have a defined boundary and the trader knows that if market is nearing one end of the boundary the move is likely to end and can go in the other direction.

Oscillators

There are technical indicators which move in a fix boundary of 0 to 100 or they can move around a central line, the distance from the line suggests their trending nature. These indicators are called oscillators as they oscillate between these two boundaries or around a line, irrespective of the market direction and strength.

An oscillator can remain at high or low levels for an extended period of time if the trend of the underlying stock is strong, but oscillators by themselves cannot trend for a sustained period of time. As they have a defined boundary they have a simple set of rules which are easier to understand. This makes oscillators one of the most powerful and popular tools in the market.

Use of Oscillators

There are three major ways in which oscillators are used by traders.

First is that oscillators are used for alerting the trader that the trend is nearing its end as it moves to one end of the boundary. In case of bounded oscillators a down trend is said to be reaching its bottom when the oscillator is reaching near the 0 mark. Similarly a trader looks to book profit or manages his stop losses aggressively if the oscillator reads a mark closer to 100.

Oscillators are also used as confirmation signal by stock market traders who do not depend only on oscillators. If price action or any other technical indicator is hinting at a signal, the trader looks up the oscillator for a confirmation signal.

Finally oscillators are used as a prediction tool. Many different strategies around oscillators have been used to suggest the future course of market movement. A simple one is the divergence between the price and the oscillator.

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Also Read : Buying climax and selling climax

Types of Oscillators

As mentioned earlier there are two main types of oscillators – bounded (or banded) oscillators which move between 0 and 100 and centered oscillators that move around the 0 line.

A bounded oscillator is best used when a stock trader is looking for overbought and oversold signals. On the other hand centered oscillators are used for analyzing the direction of price momentum.

We shall look at two common examples of each type of oscillator.

Bounded or banded oscillators

The most commonly used bounded oscillators are the Relative Strength Index (RSI) and the Stochastic.

Relative Strength Index (RSI)

RSI measures the strength of the stock with itself over a previous set date. The default setting is 14 days, but traders have played around this number to arrive at a figure which is a close fit for the market they are comfortable in trading. Generally, another line called the RSI average is used along with the RSI as this helps in smoothening the curve.

As RSI is a bounded oscillator its movement is restricted between the boundary walls of 0 and 100. But technical analysts have narrowed the leg room further for RSI by creating an overbought and oversold barrier. A stock is in the overbought zone if the RSI is near or above 70 and it is in the oversold zone when it is near or below 30.

The following chart confirms with the 70/30 overbought and oversold range. All major and minor tops and bottoms coincide when the RSI is in close proximity to the 70 and 30 values.

Bounded or banded oscillators

Stochastics

One of the most popular momentum indicator used by traders is the stochastics as it closely maps the swing in the market. The underlying principle behind this oscillator is that prices should be closing near the highs in an upswing and they should be closing near their lows in a downswing. The distance of the close price from the high and low of the day determines the strength of the swing.

Stochastics, like RSI moves between the 0 and 100 market and makes up of two lines the %K and the %D. The %K line measures the momentum of the swing move while the %D is an average of the %K line.

As in the case of RSI, traders have shortened the window of overbought and oversold for stochastics too. However, unlike RSI the commonly used points in stochastics are 80 for overbought and 20 for oversold.

The chart below shows how stochastics has oscillated between the 20 and the 80 mark corresponding with the highs and lows on the price chart.

Stochastics

Centered Oscillators

These oscillators are used by traders to gauge the strength and direction of the momentum in the market. This indicator moves around a center line, which in most cases is called the Zero line. If the line is trading above the zero line then the momentum and strength is bullish. At the same time when the line is below the zero line the momentum is dwindling and strength of the trend is waning.

The two most common forms of centered oscillators are the Rate of Change (ROC) and the Moving Average Convergence Divergence (MACD) oscillator.

Rate of Change (ROC)

That ROC indicator measures the change of the current price over a given day. Most trading app and trading software in India use a 10 day average for measuring the ROC. If the ROC is closer to 0 then the price is near the same price as it was 10 days before. The farther the ROC is above the zero line the higher will be the difference in the price from its 10 day reference point.

When the indicator moves below the zero line it indicates that the current price is below the reference point 10 days ago.

The following chart shows the main turning point has coincided with the movement of the ROC line around the zero line.Rate of Change

Moving Average Convergence Divergence (MACD)

Moving Average is a technical analysis tool which smoothen the day-to-day fluctuations of the market or helps in removing the ‘noise’ or volatility in the market. A 10 day moving average would mean the average price over the recent 10 day period. Traders combine two or more moving averages to further smoothen their entry and exit levels. Irrespective of the combination, moving averages are a lag indicator.

However, a combination of moving averages by plotting the difference between them has been found to be a leading indicator of the market direction. Moving average convergence divergence or MACD indicator is used as a momentum indicator and a leading indicator of the stock market. By plotting the difference of averages on trading app, the indicator highlights the strength of the swing and gives an early warning signal of a possible change in trend.

Many trading strategies have been developed by traders around the MACD.

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Also Read : The 5-9 Day Short Term Moving Average Rule

The chart below shows the change in MACD over the zero line corresponded with the change in price direction.

Moving Average Convergence Divergence

Conclusion

While Oscillators are very good tool for a trader, it needs to be used in conjunction with another indicator or with price action for better results. Due to which a best trading app or trading platform will be helpful.

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