Oscillators generate buy and sell signals in various ways. Some signals are geared towards early entry, while others appear after the trend has begun. In addition to buy and sell signals, oscillators can signal that something is amiss with the current trend or that the current trend is about to change. Even though oscillators can generate their own signals, it is important to use these signals in conjunction with other aspects of technical analysis. Most oscillators are momentum indicators and only reflect one characteristic of a security's price action.Volume, price patterns and support/resistance levels should also be taken into consideration.
Positive and Negative Divergences
Divergence is a key concept behind many signals for oscillators as well as other indicators. Divergences can serve as a warning that the trend is about to change or set up a buy or sell signal. There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances.
On the Merrill Lynch (MER)![[Mer]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_sG7UXdt26nqGeu6FBS7qQX2FIe2ew8t0HtO7yzi8EFWE2dlv4maevl6VSr7tKfi9X783pcmYzLK1wEt0D0_IGJ9jSJkNrJCmGi5TIYT1q9tw=s0-d)
chart, MACD formed a positive divergence in late October. While MER was trading below its previous reaction low, MACD had yet to penetrate its previous low (green arrows). However, MACD had not turned up and the positive divergence was still just a possibility. When MACD turned up and traded above its 9-day EMA, a positive divergence was confirmed. At this point, other signals came together to create a buy signal. Not only had the stock reached support and gapped up, but there was also a MACD positive divergence and a MACD bullish crossover. (Note: The thick line is the MACD and the thin line is the 9-day EMA of the MACD, which acts as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA.) After these MACD signals, the stock gapped up the very next day on a huge increase in volume.
chart, MACD formed a positive divergence in late October. While MER was trading below its previous reaction low, MACD had yet to penetrate its previous low (green arrows). However, MACD had not turned up and the positive divergence was still just a possibility. When MACD turned up and traded above its 9-day EMA, a positive divergence was confirmed. At this point, other signals came together to create a buy signal. Not only had the stock reached support and gapped up, but there was also a MACD positive divergence and a MACD bullish crossover. (Note: The thick line is the MACD and the thin line is the 9-day EMA of the MACD, which acts as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA.) After these MACD signals, the stock gapped up the very next day on a huge increase in volume.
On the IBM chart, the ROC Oscillator formed a negative divergence prior to the decline that began in January. When IBM recorded a high in mid January, the ROC Oscillator failed to surpass its previous high. The stock then began to decline and the ROC Oscillator turned lower as well, thus completing the lower high and the negative divergence. As there was little else to go on at the time, this negative divergence should have been taken as a warning signal. However, when the ROC Oscillator continued to deteriorate and broke below 0 (centerline), it was clear that the stock was weak and vulnerable to a further decline.
chart, the ROC Oscillator formed a negative divergence prior to the decline that began in January. When IBM recorded a high in mid January, the ROC Oscillator failed to surpass its previous high. The stock then began to decline and the ROC Oscillator turned lower as well, thus completing the lower high and the negative divergence. As there was little else to go on at the time, this negative divergence should have been taken as a warning signal. However, when the ROC Oscillator continued to deteriorate and broke below 0 (centerline), it was clear that the stock was weak and vulnerable to a further decline.Overbought and Oversold Extremes
Banded oscillators are designed to identify overbought and oversold extremes. Since these oscillators fluctuate between extremes, they can be difficult to use in trending markets. Banded oscillators are best used in trading ranges or with securities that are not trending. In a strong trend, users may see many signals that are not really valid. If a stock is in a strong uptrend, buying on oversold conditions will work much better than selling on overbought conditions.
In a strong trend, oscillator signals against the direction of the underlying trend are less robust than those with the trend. The trend is your friend and it can be dangerous to fight it. Even though securities develop trends, they also fluctuate within those trends. If a stock is in a strong uptrend, buying when oscillators reach oversold conditions (and near support tests) will work much better than selling on overbought conditions. During a strong downtrend, selling when oscillators reach overbought conditions would work much better. If the path of least resistance is up (down), then acting on only bullish (bearish) signals would be in harmony with the trend. Attempts to trade against the trend carry added risk.
When the trend is strong, banded oscillators can remain near overbought or oversold levels for extended periods. An overbought condition does not indicate that it is time to sell, nor does an oversold condition indicate that it is time to buy. In a strong uptrend, an oscillator can reach an overbought condition and remain so as the underlying security continues to advance. A negative divergence may form, but a bearish signal against the uptrend should be considered suspect. In a strong downtrend, an oscillator can reach an oversold condition and remain so as the underlying security continues to decline. Similarly, a positive divergence may form, but a bullish signal against the downtrend should be considered suspect. This does not mean counter-trend signals won't work, but they should be viewed in proper context and considered with other aspects of technical analysis.
The first step in using banded oscillators is to identify the upper and lower bands that mark the extremities. For RSI, anything below 30 and above 70 represents an extremity. For the Stochastic Oscillator, anything below 20 and above 80 represents an extremity. We know that when RSI is below 30 or the Stochastic Oscillator is below 20, an oversold condition exists. By that same token, when RSI is above 70 and the Stochastic Oscillator is above 80, an overbought condition exists. Identification of an overbought or oversold condition should serve as an alert to monitor other technical aspects (price pattern, trend, support, resistance, candlesticks, volume or other indicators) with extra vigilance.
The simplest method to generate signals is to note when the upper and lower bands are crossed. If a security is overbought (above 70 for RSI and 80 for the Stochastic Oscillator) and moves back down below the upper band, then a sell signal is generated. If a security is oversold (below 30 for RSI and 20 for the Stochastic Oscillator) and moves back above the lower band, then a buy signal is generated. Keep in mind that these are the simplest methods.
Simple signals can also be combined with divergences and moving average crossovers to create more robust signals. Once a stock becomes oversold, traders may look for a positive divergence to develop in the RSI and then a cross above 30. With the Stochastic Oscillator overbought, traders may look for a negative divergence and combine that with a moving average crossover and a break below 80 to generate a signal. (Note: The Stochastic Oscillator is usually plotted with a 3-day simple moving average that acts as the trigger line. When the Stochastic Oscillator crosses above the trigger line it is a bullish moving average crossover, and when it crosses below it is bearish).
The Cisco (CSCO) chart shows that the Stochastic Oscillator can change from oversold to overbought quite quickly. Much depends on the number of time periods used to calculate the oscillator. A 10-day Slow Stochastic Oscillator will be more volatile than a 20-day. The thin green lines indicate when the Stochastic Oscillator touched or crossed the oversold line at 20. The thin red lines indicate when Stochastic Oscillator touched or crossed the overbought line. CSCO was in a strong up trend at the time and experiencing little selling pressure. Therefore, trying to sell when the oscillator crossed back below 80 would have been against the uptrend and not the proper strategy. When a security is trending up or has a bullish bias, traders would be better off looking for oversold conditions to generate buying opportunities.
chart shows that the Stochastic Oscillator can change from oversold to overbought quite quickly. Much depends on the number of time periods used to calculate the oscillator. A 10-day Slow Stochastic Oscillator will be more volatile than a 20-day. The thin green lines indicate when the Stochastic Oscillator touched or crossed the oversold line at 20. The thin red lines indicate when Stochastic Oscillator touched or crossed the overbought line. CSCO was in a strong up trend at the time and experiencing little selling pressure. Therefore, trying to sell when the oscillator crossed back below 80 would have been against the uptrend and not the proper strategy. When a security is trending up or has a bullish bias, traders would be better off looking for oversold conditions to generate buying opportunities.We can also see that much of the upside for the stock occurred after the Stochastic Oscillator advanced above 80 (thin red lines). The green circle in August shows a buy signal that was generated with three separate items: one, the oscillator moved above 20 from oversold conditions; two, the oscillator moved above its 3-day MA; and three, the oscillator formed a positive divergence. Confirmation from these three items makes for a more robust signal. After the buy signal, the oscillator was in overbought territory a mere 4 days later. However, the stock continued its advance for 2-3 weeks before reaching its high.
The Microsoft (MSFT) chart reveals trading opportunities with the Relative Strength Index (RSI). Because a 14-period RSI rarely moved below 30 and above 70, a 10-period RSI was chosen to increase sensitivity. With the intermediate-term and long-term trends decidedly bearish, savvy traders could have sold short each time RSI reached overbought (black vertical lines). More aggressive traders could have played the long side each time RSI dipped below 30 and then moved back above this oversold level. The first two buy signals were generated with a positive divergence and a move above 30 from oversold conditions. The third buy signal came after RSI briefly dipped below 30. Keep in mind that these three signals were against the larger downtrend and trading strategies should be adjusted accordingly.
chart reveals trading opportunities with the Relative Strength Index (RSI). Because a 14-period RSI rarely moved below 30 and above 70, a 10-period RSI was chosen to increase sensitivity. With the intermediate-term and long-term trends decidedly bearish, savvy traders could have sold short each time RSI reached overbought (black vertical lines). More aggressive traders could have played the long side each time RSI dipped below 30 and then moved back above this oversold level. The first two buy signals were generated with a positive divergence and a move above 30 from oversold conditions. The third buy signal came after RSI briefly dipped below 30. Keep in mind that these three signals were against the larger downtrend and trading strategies should be adjusted accordingly.Centerline Crossovers
As the name implies, centerline crossover signals apply mainly to centered oscillators that fluctuate above and below a centerline. Traders have been also known to use centerline crosses with RSI in order validate a divergence or signal generated from an overbought or oversold reading. However, most banded oscillators, such as RSI and Stochastics, rely on divergences and overbought/oversold levels to generate signals. The middle ground is a bit of a no man's land for banded oscillators and is probably best left to other tools. For our purposes, the analysis of centerline crossovers will focus on centered oscillators such as Chaikin Money Flow, MACD and Rate-of-Change (ROC).
A centerline crossover is sometimes interpreted as a buy or sell signal. A buy signal would be generated with a cross above the centerline and a sell signal with a cross below the centerline. For MACD or ROC, a cross above or below zero would act as a signal.
Movements above or below the centerline indicate that momentum has changed from either positive to negative or negative to positive. When a centered momentum oscillator advances above its centerline, momentum turns positive and could be considered bullish. When a centered momentum oscillator declines below its centerline, momentum turns negative and could be considered bearish.
On this Intel (INTC) chart with MACD and ROC, there have been a number of signals generated from the centerline crossover. There were a couple of excellent signals, but there were also plenty of false signals and whipsaws. This highlights some of the challenges associated with trading oscillator signals. Also, it stresses the importance of combining various signals in order to create more robust buy and sell signals. Some traders also criticize centerline crossover signals as being too late and missing too much of the move.
chart with MACD and ROC, there have been a number of signals generated from the centerline crossover. There were a couple of excellent signals, but there were also plenty of false signals and whipsaws. This highlights some of the challenges associated with trading oscillator signals. Also, it stresses the importance of combining various signals in order to create more robust buy and sell signals. Some traders also criticize centerline crossover signals as being too late and missing too much of the move.A centerline crossover can also act as a confirmation signal to validate a previous signal or reinforce the current trend. If there were a positive divergence and bullish moving average crossover, then a subsequent advance above the centerline would confirm the previous buy signal. Failure of the oscillator to move above the centerline could be seen as a non-confirmation and act as an alert that something was amiss.
On the Intel (INTC) chart with MACD, the centerline crossover acts as the third in a series of bullish signals. Even after the third signal, Intel still has plenty of upside left.
chart with MACD, the centerline crossover acts as the third in a series of bullish signals. Even after the third signal, Intel still has plenty of upside left.- There was the higher low forming that signaled a potential positive divergence.
- There was the bullish moving average crossover to confirm the positive divergence.
- And finally, there was the bullish centerline crossover.
Some traders would worry about missing too much of the move by waiting for the third and final confirmation. However, this can be a more reliable signal and help to avoid whipsaws and false signals. It is true that waiting for the third signal will reduce profits, but it can also help reduce risk.
Chaikin Money Flow is an example of a centered oscillator that places importance on crosses above and below the centerline. Divergences, overbought levels and oversold levels are all secondary to the absolute level of the indicator. The direction of the oscillator's movement is important, but needs to be placed in the context of the absolute level. The longer the oscillator is above zero, the more evidence of accumulation. The longer the oscillator is below zero, the more evidence of distribution. Hence, Chaikin Money Flow is considered to be bullish when the oscillator is trading above zero and bearish when trading below zero.
On the IBM chart, Chaikin Money Flow began to turn down in July. At this time, the stock was declining with the market and the decline in the oscillator was normal. However, in the second half of August, concerns began to grow when the oscillator failed to continue up with the stock and fell below zero. As the stock advanced further, Chaikin Money Flow continued to deteriorate. This served as a signal that something was amiss.
chart, Chaikin Money Flow began to turn down in July. At this time, the stock was declining with the market and the decline in the oscillator was normal. However, in the second half of August, concerns began to grow when the oscillator failed to continue up with the stock and fell below zero. As the stock advanced further, Chaikin Money Flow continued to deteriorate. This served as a signal that something was amiss.Pros and Cons of Oscillator Signals
Banded oscillators are best used to identify overbought and oversold conditions. However, overbought is not meant to act as a sell signal, and oversold is not meant to act as a buy signal. Overbought and oversold situations serve as an alert that conditions are reaching extreme levels and close attention should be paid to the price action and other indicators.
To improve the robustness of oscillator signals, traders can look for multiple signals. The criteria for a buy or sell signal could depend on three separate yet confirming signals. A buy signal might be generated with an oversold reading, positive divergence and bullish moving average crossover. Conversely, a sell signal might be generated from a negative divergence, bearish moving average crossover and bearish centerline crossover.
Traditional chart pattern analysis can also be applied to oscillators. This is a bit trickier, but can help to identify the strength behind an oscillator's move. Looking for higher highs or lower lows can help confirm previous analysis. A trend line breakout can signal that a change in the direction of the momentum is imminent.
It is dangerous to trade an oscillator signal against the major trend of the market. In bull moves, it is best to look for buying opportunities through oversold signals, positive divergences, bullish moving average crossovers and bullish centerline crossovers. In bear moves, it is best to look for selling opportunities through overbought signals, negative divergences, bearish moving average crossovers and bearish centerline crossovers.
And finally, oscillators are most effective when used in conjunction with pattern analysis, support/resistance identification, trend identification and other technical analysis tools. By being aware of the broader picture, oscillator signals can be put into context. It is important to identify the current trend or even to ascertain if the security is trending at all. Oscillator readings and signals can have different meaning in differing circumstances. By using other analysis techniques in conjunction with oscillator reading, the chances of success can be greatly enhanced.
