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Traders find many different types of ‘indicators’ that can be used to identify and evaluate trading opportunities. Moving averages is one such type, which I have already covered in previous columns. Oscillators are another very popular type of indicator.
By understanding how oscillators are calculated, we’re better equipped to correctly interpret the information that the indicator is giving us.
An oscillator is a technical analysis indicator that varies over time within a band, either above and below a centre line, or between two absolute levels. It is essentially a calculation applied to price, which plots a line over time. It moves either above or below a centre point, or between two absolute levels – usually zero
and 100.
It therefore either oscillates above or below a neutral point, or between the two extreme levels. This allows traders to interpret the way in which the oscillating indicator moves, either by itself or in comparison to price, in order to generate signals and convey meaning.
This makes oscillators a handy tool to indicate short-term overbought or oversold conditions for a security. In normal English: The oscillator tries to pinpoint when a security price move has overextended in a particular direction and is due for a reversal.
Oscillators, for the most part, attempt to measure the momentum of a price movement and can be used to indicate when that directional momentum is changing.
Trading signals can be generated either when an oscillator moves through a set level in or from a certain direction, or (as is usually the case) a moving average is added to the line that the oscillator plots and the oscillator itself crosses over its own moving average.
Oscillators can also be used to indicate a divergence in momentum and price, thus potentially indicating trend-changing scenarios before they take place.
A trader will compare a series of consecutive highs and lows in the security price with the highs and lows of the oscillator indicator and seek out times that there are discrepancies. When, for example, price is making higher highs, but the oscillator is making lower highs, it is indicative of a potential change in the security price trend from bullish to bearish.
Divergence can be a powerful tool to use when evaluating a potential trade. Leaning on some of the concepts already covered, let’s use a scenario to explain.
Let’s say that you have identified the primary trend as an uptrend, or bullish trend. Therefore, the secondary trend is bearish, although the security price has come down to the primary trendline.
This creates a potential long entry in order to trade in the direction of the primary trend, provided that the primary trendline provides support and that price does not breach below it.
We can go further to say that the secondary trend, being the bearish price movement down to the primary trendline, took the shape of a falling wedge formation, which in this scenario is a bullish continuation pattern.
There are now two reasons to be on the lookout for long entries as; 1. you want to trade with the primary trend and, 2. there is a bullish long-term price pattern present.
Now let’s imagine that while the secondary trend has been moving price lower in a series of lower highs and lower lows (as trends do), you notice that the oscillator indicator has, during the course of the secondary trend, made higher lows that coincide with the lower lows made by price.
This divergence between the trends present on price and on the oscillator is now indicative that a bullish reversal might take place. In other words, it is signaling that the current secondary downtrend could reverse, and a new uptrend could emerge.
Of course, in this scenario that would be a continuation of the primary trend. This now gives you a third reason to be on the lookout for long entries as the ‘divergence’ provides further evidence that the security price is likely to move higher. You would still need a trigger to enter into the trade, which would likely be the breakout of the long-term price pattern.
It goes without saying that you would need to set a stop-loss as well in order to proactively manage risk. What the divergence gives you though is an indication that a trend (secondary) change is possible, thus adding evidence that a bullish move in price is possible.
Petri Redelinghuys is a trader and the founder of Herenya Capital Advisors.
This article originally appeared in the 29 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
