Technical Analysis – The Most Important Oscillators

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Oscillators are technical indicators that are applied at the bottom of a currency pair’s chart. They are calculated based on different mathematical formulas and the idea behind plotting an oscillator is to look for differences between its moves and the way price is moving. Oscillators are more popular among Forex traders. A simple look at the default oscillators list offered by the MetaTrader4 is telling 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 that have a stronger risk tolerance than others. It is being said that, when trading the Forex market, one should not risk capital that cannot be lost. This is the cornerstone of any risk disclaimer. If that is true, then oscillators would not be that popular. You see, oscillators are favored 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 bigger than in the case of trading with trend indicators. Nevertheless, only the idea that a bigger profit can be made is enough for the 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 Ones

We’re not going to discuss here all the oscillators that populate that list, but the ones that are the most representative ones. Keep in mind that, like trend indicators, oscillators are showing the same thing, no matter the one that is being used. The trend indicators, as explained in the previous article here at the Trading Academy, are used by traders to find out places to buy in a bullish trend and sell in a bearish one. Basically, buy the dip and sell the spike approach when riding a strong trend. Oscillators, on the other hand, are used to find out overbought and oversold levels, as well as bullish and bearish divergences. As a quick description, a divergence is forming when the oscillator is not confirming 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 is traveling between the 0 and 100 levels, and therefore it is always a positive one.
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.

This is not enough, though. The chart above shows that price can stay oversold for quite sometimes and if the risk-tolerance is not confirmed by a bigger trading account, heavy losses can be taken. Overbought and oversold levels are working very well in a ranging environment that is supposed to see indecision in the market. This is happening mostly in the Asian session, in most of the crosses, and ahead of major economic events like the Non-Farm Payrolls (NFP) release in the United States.

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Moving Average Convergence Divergence (MACD)

The MACD appeals to traders because it has a visible signal line. This is either rising or falling, indicating the overall trend, bullish or bearish. The oscillator is more powerful the bigger the time frame it is applied on is. Another way to look at it is to treat it as a continuation pattern. It means to buy 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) is reversing.

Divergences can be successfully traded here as well, and overbought and oversold levels are to identified based on the height of the histogram has. That is, the area the gray candles is forming.

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Stochastics Oscillator

The Stochastics is, in many ways, similar with the RSI. It is showing 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 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 is working only some of the times, like any other trend indicator or oscillator.

Some say that the Stochastics oscillator is resembling more with a momentum indicator rather than being an oscillator on its own. The explanation for this is the fact that the swings from overbought to oversold levels are quite often and it fails to show the true value of an overbought/oversold area like the RSI does. DeMarker, Momentum, Relative Vigor Index (RVI) or 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, it is almost similar with 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? The RVI is like the Stochastics, while the Momentum indicator is resembling the MACD as they both travel above or beyond the zero level. One approach on the first one should bear the same fruits in the second one. Divergences with oscillators are the ones that make them so popular among Forex traders. 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, he/she might wait for the market to form a divergence on the favorite oscillator. Because oscillators are somehow similar, (as explained in this article) if a divergence is seen on one oscillator, it is most likely that 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 show the same thing. A divergence, though, is confirming a bullish or a bearish bias. This is enough for traders to pull the plug in a bad trend or to open a new position. The differences between trend indicators and oscillators are being given by the nature of the traders that are using them. Conservative traders will always favor 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 much to enter/exit a trade is damaging the overall performance in a trading account.

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Recommended Further Readings

  • Basic Trading Styles – At Market or with Pending Orders
    – Showing the possibilities a trader has, explaining the advantages and disadvantages of trading at the market or with pending orders.
  • Pending Orders Explained
    – Different types of pending orders, how to set them, where to find them on the MetaTrader platform, and much more.
  • Forex Market Participants
    – Who is participating in the Forex market, its structure, componence, and implications of different groups.
  • Trading on a Demo Account
    – Explaining why trading on a demo account before going on a live one is mandatory for any serious trader.
  • Types of Forex Charts
    – How many types of Forex charts exist, how to interpret them, advantages and disadvantages of each type, etc.
  • Basics of Technical Analysis
    – What is technical analysis, why it is important and why traders are using it. Advantages over fundamental analysis are highlighted as well.

Other Educational Materials

  • Evolutionary algorithm in forex trade strategy generation. Myszkowski, P.B. and Bicz, A., 2010, October.In Computer Science and Information Technology (IMCSIT), Proceedings of the 2010 International Multiconference on (pp. 81-88). IEEE.
  • Optimization of technical trading rules in forex market using genetic algorithm Silva PF. (Doctoral dissertation).

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