Think of a technical indicator that tells you when to buy a market that’s fallen too low, and sell one that has risen too high. Sounds like a dream, yes? Well, that’s how the humble oscillator has been sold to traders for years. But is this form of indicator really the Holy Grail of technical analysis? If only it were as easy as that.
Where making money is involved, there is no easy answer or free lunch. If there was, we’d all be doing it and becoming millionaires after a couple of years. No, making money, winning, and getting rich all require blood, sweat, and effort. And using technical analysis is no different.
Anyone familiar with market price action will be aware that markets tend to trend, in one of three directions—up, down, and sideways. In fact, some people actually call sideways movement in a market, “trendless”, but this is just semantics. The key element on which to focus is the word, “trend”. When markets are trending up or down, then the best policy is just to ride them out until the trend changes to neutral (sideways, trendless), or turns towards the totally opposite direction. We’ll put trending markets to the side for the moment, to concentrate on markets that rise, then fall and then rise again, all in a clearly defined price range. And markets do this, on average, for a third of their life cycle, so you’d better get used to it.
One of the most popular technical indicators to use during periods of sideways market price action is the oscillator. These mathematical equations are used to determine when the price has been at the top of the trading range for a period of time, and when it’s due for a correction. When markets are trading at those extremes—either top of the range or bottom of the range—then markets are often termed overbought (range top) or oversold (range bottom). At these points, traders have an opportunity to put on a nice trade with a stop just outside of the previously-defined trading range.
Take one of the simplest of the oscillators—Momentum. This is calculated by taking today’s price and subtracting from it the price x days in the past, let’s say 10. If today’s price is 95, and the price 10 days ago was 91, then today’s momentum is +4, and this suggests that the price has risen. But what is interesting to us is when prices will start to slip into negative territory. For this, the Momentum indicator uses a zero line, where prices, say 10 days ago are equal to today’s price. Subtracting the two prices give us zero, and this is the point at which prices are likely to turn.
But there is one other factor to consider—divergence. If it were simply the case that crossing the zero line gave a buy or sell signal, then life would be easy, but as mentioned above, no free lunches, remember? No, the REAL buy or sell indicator occurs when prices cross the zero line, and there is a divergence between the Momentum indicator and the price action. To put it simply, if the price action has peaked and then, several periods later it makes a new higher peak, while the Momentum indicator has peaked, but makes a lower high, that is called “divergence”. If at that point the Momentum indicator crosses the zero line, then that is the time to put on the trade.
This may sound a little complex, but it’s really not. And the same principle applies to all of the other oscillators such as Rate of Change (RoC), Moving Average Convergence/Divergence (MACD), and the famous Relative Strength Index (RSI). Any trader who wants to use technical analysis to put on trades at the optimal time and position must learn about these indicators. So, do yourself a favor, and get hold of one of the many classic textbooks on the subject and start hunting for those divergence opportunities. You’ll be amazed by how easy they become to spot.