Trend following indicators include moving averages, On Balance Volume, Larry Williams’ Accumulation-Distribution, the popular Moving Average Convergence Divergence (or MACD), and others. As the name implies, trend following indicators tend to move with the stock. They are considered lagging because they generally turn after a trend has already reversed course.
The definition of the word oscillate is, “to swing or move to and fro, as a pendulum does.” On stock charts, oscillators do exactly that, they move higher and lower and help identify turning points for a stock. In the book Trading for A Living, Dr. Alexander Elder put it this way,
Oscillators help to identify the emotional extremes of crowds. They allow you to find unsustainable levels of optimism and pessimism. Professionals tend to fade those extremes. They bet against them, for a return to normalcy. When the market rises and the crowd gets up on its hind legs and roars from greed, professionals sell short. They buy when the market falls and the crowd howls from fear. Oscillators help them to time those trades.
There are a number of different oscillators available to the trader today. One of the most popular is Stochastics. Other oscillators include Rate of Change, Williams % R, Chaos MO and AO, and others. Each is designed to gauge whether prices have been driven to extremes. For instance, when prices rise too high, a stock is considered overbought and it is likely to fall. On the other hand, when prices fall too far, the stock is oversold and likely to rally. Each oscillator has its own reference points and will generate buy or sell signals when prices deviate too far from what is considered normal.
To see how oscillators work, let’s consider the Relative Strength Indicator [RSI]. Developed by Welles Wilder, RSI is a popular indicator. The relative strength index is generally viewed on a stock chart underneath the price chart. For instance, the chart below includes the recent price action of SSI (SOFTSOL) along with RSI.
There are basically three ways to use the Relative Strength Index. Most other oscillators are used the same way.
The first is to identify overbought and oversold conditions. RSI will fluctuate between 0 and 100. On the chart above, the RSI on SSI has been between, roughly, 40% and 70%, which is the range for a sideways market. The indicator has moved above 70% in late-November 2001 and again in late-April 2002, it signaled overbought conditions and hinted at a snapback. In early April 2002, the indicator dipped below 30 thus sigannling oversold conditions.
The second way to use oscillators is as a confirmation tool. For instance, when looking at trends, the technical analyst wants to see the RSI setting new highs or new lows along with the stock. For instance, when SSI set a new high in mid-January 2002, RSI did not. That signaled what is known as a bearish divergence and hinted that a reversal might be on the way.
Finally, when looking at the relative strength index, the chart analyst wants to consider the slope of the indicator. An upward sloping RSI is the sign of a healthy advance and a downward sloping RSI is evidence of a strong decline. Most oscillators are used in the same fashion as RSI, but each is unique in its own way and must be considered individually.
Nevertheless, oscillators like RSI are useful in finding turning points in a stock. For that reason, they work better when a stock is in a trading range, rather than in a trending market. In trending markets, oscillators can give premature and inaccurate signals, but when a stock is in a trading range, you will find that these tools can help pinpoint important turning points remarkably well.
