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Two Rules For Trading With Oscillators
Oscillators are among the most common and widely used technical indicators. That is because this type of analysis can be applied to any time frame, any asset class and even to other indicators. For the uninitiated, an oscillator is an indicator that displays beneath a chart and appears as a wavy line moving above and below zero, or between two extremes. There are many kinds of oscillators, some are better than others, but they all share some basic characteristics regardless of how they are derived. For one, they are all displayed in similar fashion, the wavy line between two extremes. Second, they all provide a wide range of signals including entry points, support, resistance, potential reversals and potential break outs. One of the biggest benefits of an oscillator is that it can be used to give bullish and bearish signals. However, that benefit can be a two edged sword if not applied correctly.
- By definition an oscillator is the repetitive variance about a central point or point of equilibrium over time or between two opposite states. In the case of technical analysis these two opposite states are Overbought and Oversold. If a market is Overbought selling and a falling market could be expected. If a market is Oversold buying and a rising market may be expected. The zero line, or mid point, can be equated to market balance. When an oscillator crosses the mid point the balance is shifting from buyers to sellers or vice versa.
In essence, an oscillator is an EKG of the market. An EKG is an electrical reading of your hearts out put and displays on a graph. The graph tells the story of your hearts health; a specialist can read volumes from that graph. Such is the case with oscillators. Some common types frequently used include Stochastic, RSI, MACD and many many more. I have even discovered a stochastic RSI which applies stochastic analysis to RSI readings but more on that in a future post. Stochastic is based on random walk theory and Brownian Motion. It assumes that short market movement is random and unpredictable. By analyzing that randomness over a set time period patterns emerge and longer term direction can be determined. MACD is based on a pair of moving averages, one shorter term, one longer term. The indicator measures the movement of the short term moving average in relation to the longer one providing an insight into market strength. RSI measures the strength of the market versus previous strength and weakness.
Look at the graphic below. I have a stack of oscillators including stochastic, MACD, RSI and one I have found called the Ultimate Oscillator. You can see that there are many similarities. Each provides a unique view of the markets but in the end they all give off similar signals. You can see from where I have drawn my arrows just how similar they are. My advice to new traders is to pick 1 or 2 of this type of indicator, it doesn’t matter which ones, and learn them inside and out. Choose the ones that look good to you, the ones whose lines speak to you. I use MACD and stochastic because they are the ones I learned first and know best. I have been using them so long I can read them like a book.
How To Use An Oscillator
The most basic and reliable signal an oscillator can give is the trend following signal. For this reason it is necessary to establish trend first. Oscillators will also work in range bound conditions but I will get to that in a minute. Because these indicators can give signals in both directions the first rule in using them is to only take signals that follow the trend. In an uptrend a buy signal is when the oscillator moves lower in the range and makes a dip. This dip will not always move down into the oversold territory, the trick is to read the dips in relation to other analysis such as support, resistance or fundamental changes. Sometimes, in a strongly trending market, a dip may very shallow and barely move out of the OB/OS extreme. On the chart below the 6 trend following bull signal resulted in more than $43 of movement on the SPY, an 83% win ratio and more than enough for binary traders to show a profit. Out of 8 bear signals on this chart four were profitable on a short term basis, yielding a net gain of $25 and a losing win ratio of only 50%. The bear signals, in this instance, in both stochastic and MACD, are better used as confirmations of support along the trend line.
- Rule Number One – Only use trend following signals.
Oscillators can also be used with ranging assets. The beauty of this technique is that it is possible to use both bullish and bearish signals. As the assets moves up towards the top of the range the oscillators will provide bullish signals until it reaches resistance. At that point observant traders can then await a bear signal and trade the reverse position with the lower end of the range as a target. The same is true in reverse. This technique is a little more risky because it can provide more false signals. Breaks above and below the range are not uncommon and should only be traded on with a firm confirmation.
- Rule Number Two – Beware false break outs when an asset is ranging.
Trading with Oscillators – Overbought and Oversold Levels
Depending on the oscillator, the overbought and oversold, or the extreme levels, differ. For example:
- with the most popular oscillator, the RSI (Relative Strength Index), overbought is 70 and oversold is 30
- on the DeMarker, overbought is 0.7 and oversold is 0.3
- on CCI, overbought is anything above +100, and oversold is anything below -100.
And the list can go on. Even the oscillators that don’t have predefined levels, traders can build them.
For example, a quick study of the historical prices tells one where the market tends to turn. Hence, traders have an idea about overbought and oversold levels.
Buying Oversold and Selling Overbought
This is the oldest trick in the trading books. Thus, everyone knows it, so it fails often.
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One solid argument will be: why do traders use the principle anymore if it fails so often?
The right answer is that it fails ONLY when certain conditions are met. Namely, when the market is in a trend. When it ranges, the overbought and oversold levels work like a charm.
Below there is the recent USDCAD daily chart. The example is an eloquent one as it demonstrates the connection between overbought and oversold levels and trending and ranging conditions. As for the oscillator, we used the RSI with the default 14 periods.
It means that for every value that the RSI plots on that small window, it considers the previous fourteen candles or days.
From left to right, the market forms a robust and bearish trend. That’s the corresponding move of the oil price bouncing from below the $30 level after it dropped like a rock, causing the 1.46 surge in the USDCAD pair.
For those that don’t know, the oil and CAD enjoy a direct correlation. Because the Canadian economy is an energy driven one, oil plays a vital role in its GDP (Gross Domestic Product).
Trying to buy when the RSI reaches the 20 level makes no sense, as the trend keeps going and going. However, a range that took almost an entire year starts. Selling 70 and buying 30 RSI levels prove to be the right strategy.
The following trending and ranging conditions show the same thing. Hence, the key in trading overbought and oversold levels stays with finding ranging and trending conditions.
Bullish and Bearish Divergences – Another Way of Trading with Oscillators
Another way of trading with oscillators is to look for divergences. A divergence happens when the price moves in one direction, and the oscillator doesn’t confirm that move.
Thus, because the oscillator considers multiple periods, traders choose to stay with what the oscillator shows.
A divergence is either bullish or bearish and forms with any oscillator. To spot it, look for the price to form two consecutive highs, while the oscillator fails to make the second high.
In other words, the oscillator diverges from the price’s move. Ideally, the oscillator will already be in overbought territory.
For a bearish divergence, traders wait for the price to make two consecutive lows. At the same time, the oscillator fails to confirm the second low, thus diverging from the price’s move.
As already stated, traders should stay with the oscillator’s move, not with the one made by the price.
How to Trade a Divergence
To trade a divergence, first, you need to identify one. In some instances, the market forms one divergence after another, just like the recent EURUSD chart.
This time the oscillator used is DeMarker. It appears with the default settings on all trading platforms, MT4 included.
From left to right, the market forms a bearish divergence. The EURUSD four-hour timeframe shows two highs the price made, but the oscillator fails to confirm the second high.
Hence, a bearish divergence (pictured in black) forms. The way to trade it is to wait for the oscillator to come back below the overbought area (below 0.7) and stay on the short side until the overbought area comes (0.3 level).
Immediately after, the price makes two consecutive lows, while the DeMarker fails to confirm the second low. That’s a bullish divergence (shown in blue), and the way to trade is to go long when the oscillator crosses above 0.3 and stay on the long side until 0.7 comes.
Trading with oscillators is straightforward. There’s no catch, and the rules are the same, regardless of the oscillator.
However, all traders know the standard interpretation. It is no secret now how divergences work and what to do when the price reaches overbought and oversold levels.
The thing is that the price may remain overbought more than a trader affords to remain solvent. Or, the price may diverge more than the trader has funds in the account to fade the move.
All in all, oscillators are great tools used together with other technical analysis instruments. Trendlines and channels, support and resistance, and even trading theories come together to confirm the signal generated by oscillators.
Using Technical Indicators to Develop Trading Strategies
Indicators, such as moving averages and Bollinger Bands®, are mathematically-based technical analysis tools that traders and investors use to analyze the past and anticipate future price trends and patterns. Where fundamentalists may track economic data, annual reports, or various other measures of corporate profitability, technical traders rely on charts and indicators to help interpret price moves.
The goal when using indicators is to identify trading opportunities. For example, a moving average crossover often signals an upcoming trend change. In this instance, applying the moving average indicator to a price chart allows traders to identify areas where the trend may run out of gas and change direction, which creates a trading opportunity.
- Technical indicators are used to see past trends and anticipate future moves.
- Moving averages, relative strength index, and stochastic oscillators are examples of technical indicators.
- Trading strategies, including entry, exit, and trade management rules, often use one or more indicators to guide day-to-day decisions.
- There is no evidence to suggest that one indicator is foolproof or a holy grail for traders.
- Strategies (and indicators used within those strategies) will vary depending on the investor’s risk tolerance, experience, and objectives.
Strategies frequently use technical indicators in an objective manner to determine entry, exit, and/or trade management rules. A strategy specifies the exact conditions under which traders are established—called setups—as well as when positions are adjusted and closed. Strategies typically include the detailed use of indicators (often multiple indicators) to establish instances where trading activity will occur.
While this article does not focus on any specific trading strategy, it serves as an explanation of how indicators and strategies are different (and how they work together) to help technical analysts identify high-probability trading setups.
A growing number of technical indicators are available for traders to study, including those in the public domain, such as a moving average or the stochastic oscillator, as well as commercially available proprietary indicators. In addition, many traders develop their own unique indicators, sometimes with the assistance of a qualified programmer. Most indicators have user-defined variables that allow traders to adapt key inputs such as the “look-back period” (how much historical data will be used to form the calculations) to suit their needs.
A moving average, for example, is simply an average of a security’s price over a particular period. The time period is specified in the type of moving average, such as a 50-day or 200-day moving average. The indicator averages the prior 50 or 200 days of price activity, usually using the security’s closing price in its calculation (though other price points, such as the open, high, or low, can also be used). The user defines the length of the moving average as well as the price point that will be used in the calculation.
A strategy is a set of objective, absolute rules defining when a trader will take action. Strategies typically include trade filters and triggers, both of which are often based on indicators. Trade filters identify the setup conditions; trade triggers identify exactly when a particular action should be taken. A trade filter, for example, might be a price that has closed above its 200-day moving average. This sets the stage for the trade trigger, which is the actual condition that prompts the trader to act. A trade trigger might occur when the price reaches one tick above the bar that breached the 200-day moving average.
A strategy that is too basic—like buying when price moves above the moving average—is usually not viable because a simple rule can be too evasive and does not provide any definitive details for taking action. Here are examples of some questions that need to be answered to create an objective strategy:
- What type of moving average will be used, including length and price point used in the calculation?
- How far above the moving average does price need to move?
- Should the trade be entered as soon as price moves a specified distance above the moving average, at the close of the bar, or at the open of the next bar?
- What type of order will be used to place the trade? Limit or market?
- How many contracts or shares will be traded?
- What are the money management rules?
- What are the exit rules?
All of these questions must be answered to develop a concise set of rules to form a strategy.
Using Technical Indicators to Develop Strategies
An indicator is not a trading strategy. While an indicator can help traders identify market conditions, a strategy is a trader’s rule book and traders often use multiple indicators to form a trading strategy. However, different types or categories of indicators—such as one momentum indicator and one trend indicator—are typically recommended when using more than one indicator in a strategy.
Many different categories of technical charting tools exist today, including trend, volume, volatility, and momentum indicators.
Using three different indicators of the same type—momentum, for example—results in the multiple counting of the same information, a statistical term referred to as multicollinearity. Multicollinearity should be avoided since it produces redundant results and can make other variables appear less important. Instead, traders should select indicators from different categories. Frequently, one of the indicators is used to confirm that another indicator is producing an accurate signal.
A moving average strategy, for example, might employ the use of a momentum indicator for confirmation that the trading signal is valid. Relative strength index (RSI), which compares the average price change of advancing periods with the average price change of declining periods, is an example of a momentum indicator.
Like other technical indicators, RSI has user-defined variable inputs, including determining what levels will represent overbought and oversold conditions. RSI, therefore, can be used to confirm any signals that the moving average produces. Opposing signals might indicate that the signal is less reliable and that the trade should be avoided.
Each indicator and indicator combination requires research to determine the most suitable application given the trader’s style and risk tolerance. One advantage of quantifying trading rules into a strategy is that it allows traders to apply the strategy to historical data to evaluate how the strategy would have performed in the past, a process known as backtesting. Of course, finding patterns that existed in the past does not guarantee future results, but it can certainly help in the development of a profitable trading strategy.
Regardless of which indicators are used, a strategy must identify exactly how the readings will be interpreted and precisely what action will be taken. Indicators are tools that traders use to develop strategies; they do not create trading signals on their own. Any ambiguity can lead to trouble (in the form of trading losses).
Choosing Indicators to Develop a Strategy
The type of indicator a trader uses to develop a strategy depends on what type of strategy the individual plans on building. This relates to trading style and risk tolerance. A trader who seeks long-term moves with large profits might focus on a trend-following strategy, and, therefore, utilize a trend-following indicator such as a moving average. A trader interested in small moves with frequent small gains might be more interested in a strategy based on volatility. Again, different types of indicators may be used for confirmation.
Traders do have the option to purchase “black box” trading systems, which are commercially available proprietary strategies. An advantage to purchasing these black box systems is that all of the research and backtesting has theoretically been done for the trader; the disadvantage is that the user is “flying blind” since the methodology is not usually disclosed, and often the user is unable to make any customizations to reflect their trading style.
The Bottom Line
Indicators alone do not make trading signals. Each trader must define the exact method in which the indicators will be used to signal trading opportunities and to develop strategies. Indicators can certainly be used without being incorporated into a strategy; however, technical trading strategies usually include at least one type of indicator.
Many companies offer expensive newsletters, trading systems, or indicators that promise large returns but do not produce the advertised results. Checking reviews and asking for a trial period can help identify the shady operators.
Identifying an absolute set of rules, as with a strategy, allows traders to backtest to determine the viability of a particular strategy. It also helps traders understand the mathematical expectancy of the rules or how the strategy should perform in the future. This is critical to technical traders since it helps to continually evaluate the performance of the strategy and can help determine if and when it is time to close a position.
Traders often talk about a holy grail—the one trading secret that will lead to instant profitability. Unfortunately, there is no perfect strategy that will guarantee success for each investor. Each individual has a unique style, temperament, risk tolerance, and personality. As such, it is up to each trader to learn about the variety of technical analysis tools that are available, research how they perform according to their individual needs, and develop strategies based on the results.
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