Technical Analysis – The Most Important Oscillators

Oscillators are technical indicators that are applied at the bottom of a currency pair’s chart. They are calculated based on different mathematical formulas, the idea behind plotting an oscillator being to look for differences between its moves and the way the price is moving. Oscillators are mainly popular among Forex traders. A simple look at the default oscillators list offered by MetaTrader4 tells us that they outnumber trend indicators. The reason for their popularity is strongly related to how we, as humans, perceive risk. Traders are, in general, people who have a stronger risk tolerance than others. It is said that when trading the Forex market, one should not risk capital that one cannot afford to lose. This is the cornerstone of any risk disclaimer. If that is true, though, then oscillators would not be that popular. You see, oscillators are favoured by Forex traders because they allow for tops and bottoms to be picked. What Forex trader doesn’t want to be able to sell a currency pair right at the top, or to buy it right at the bottom? Oscillators can offer that possibility, but the risk involved is higher than in the case of trading with trend indicators. Nevertheless, the mere idea that a bigger profit can be made is enough for this risk warning to be ignored, and this is the main reason why there is such a big list of default oscillators.

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Describing the Most Popular Oscillators

We’re not going to discuss here all the oscillators that populate that list, but only the most representative ones. Bear in mind that, like trend indicators, oscillators all show the same thing, regardless of which one is being used. Trend indicators, as explained in the previous article here at the Trading Academy, are used by traders to pinpoint places to buy in a bullish trend and sell in a bearish one. Basically, one should use the “buy the dip and sell the spike” approach when riding a strong trend. Oscillators, on the other hand, are used to identify overbought and oversold levels, as well as bullish and bearish divergences. As a quick description, a divergence forms when the oscillator does not confirm the move the price makes.

Relative Strength Index (RSI)

The RSI is so popular that it is the main choice when looking for an oscillator to be applied to a chart. It travels between the 0 and 100 levels, and so it is always positive. However, it is extremely rare that you’ll see a move above 80 or one below 20, and the overbought and oversold area is defined by any move above 70 and any move below 30. The general idea is to sell an overbought move and to buy an oversold one.
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This is not enough, though. The chart above shows that price can stay oversold for quite some time, and if the risk tolerance is not confirmed by a bigger trading account, heavy losses can be suffered. Overbought and oversold levels work very well in a ranging environment, which is supposed to show indecision in the market. This happens mostly in the Asian session, with most of the crosses, and ahead of major economic events such as the Non-Farm Payrolls (NFP) release in the United States.

Moving Average Convergence Divergence (MACD)

The MACD appeals to traders because it has a visible signal line. This is either rising or falling, indicating whether the overall trend is bullish or bearish. The oscillator is more powerful the longer the timeframe it is applied on. Another way to look at it is to treat it as a continuation pattern. It means buying the zero-level cross as a continuation of the previous trend: That is, if the price is falling and the MACD crosses the zero level, we should add to a short position until the signal line (the red one in the chart below) reverses.
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Divergences can be successfully traded here as well, and overbought and oversold levels are identified based on the height of the histogram: that is, the area where the gray candles are forming.

Stochastics Oscillator

The Stochastics oscillator is, in many ways, similar to the RSI. It shows overbought and oversold levels, and travels only in positive territory. An overbought level is defined by a move above 80, while an oversold level is defined by a move below 20. There is a cross between a fast and a slow Stochastics line that needs to happen in the overbought or oversold level.This cross represents the signal to sell or to buy. Unfortunately, this approach only works some of the time, as with any other trend indicator or oscillator.
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Some say that the Stochastics oscillator  more resembles a momentum indicator rather than being an oscillator in its own right. The explanation for this is that swings from overbought to oversold levels are quite frequent, and it fails to show the true value of an overbought/oversold area like the RSI does. DeMarker, Momentum, Relative Vigor Index (RVI), and William’s Percent Range are all oscillators that resemble the ones described above. DeMarker, for example, while having a different mathematical formula at its core, is very similar to the RSI. In fact, if you plot the two on the same chart, you’ll see that the moves are almost identical. What’s the point in using them both, then? It’s because the RVI is like the Stochastics indicator, while the Momentum indicator resembles the MACD, as they both travel above or beyond the zero level. An approach on the first one should bear the same fruit on the second one. Divergences identified by oscillators are the things that make them so popular among Forex traders, as a divergence comes to confirm the bullishness or bearishness of a scenario. If for example, a trader is using the Elliott Waves theory to forecast future prices, and the outcome is a bullish one, they might wait for the market to form a divergence on their favourite oscillator. Because all oscillators are somewhat similar (as explained in this article) if a divergence is seen on one oscillator, it is most likely that it will form on other ones too. For this reason, it makes no sense to crowd the trading screen with multiple oscillators because, in the end, they will all show the same thing. A divergence, though, does confirm a bullish or a bearish bias, and this is enough to allow traders to pull the plug on a bad trend or to open a new position.

The differences between trend indicators and oscillators reflect the nature of the traders who use them. Conservative traders will always favour trend indicators, while aggressive ones will opt for oscillators. If anything, conservative traders will look at an oscillator only to have yet another signal that the trade is a safe one. This, in turn, leads to lost opportunities in the Forex market, as waiting too long to enter or exit a trade damages the overall performance of a trading account.

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