Oscillator Indicators Part I
MG Financial offers a variety of technical tools in its
Charts and News software
, including a combination of Trend and Oscillator indicators. The trend indicators, mainly the Moving Averages and Bollinger Bands, were discussed in the
Trend Indicators article. We will take this opportunity to discuss various analytical tools and the services offered through the use of Oscillator Indicators.
Oscillator Indicators can be used in conjunction with the trend indicators by alerting the trader of short-term market 'extremes,' commonly referred to as overbought and oversold conditions. MG offers a mix of simple indicators like Momentum and Rate of Change, with more advanced indicators such as the Relative Strength Index (RSI), Moving Average Convergence/Divergence (MACD), and Stochastics.
Momentum:
The Momentum indicator serves as a building block and a crucial concept of oscillator analysis. Momentum measures the rate of price change rather than the actual prices, as compared to the trend indicators that measure the actual price levels. The formula for momentum is as follows:
M = P- Pn
Where: P = Latest Closing price, n = Predetermined number of days, Pn = Closing price of n days ago.
The formula will result in an array of positive and negative values that are plotted around a zero line. If the latest closing is higher than it was 'n' days ago, a positive value will be plotted above the zero line; if the latest closing price is lower than the price 'n' days ago, a negative value will be plotted below the zero line.
In the figure above, a 10-day momentum line has been plotted for EUR/USD using the daily chart. The red circles highlight the overbought and oversold conditions on the momentum line. When the momentum line is far out above the zero line, red circles signify overbought conditions while the circles on the lower extremes of the momentum line demonstrate oversold conditions.
Overbought conditions are treated as sell warnings while oversold conditions are regarded as warning signals to buy. Traders can use MG's charts to plot the momentum line over the time period of their choice. A shorter time period produces a more sensitive line with more pronounced movements while a longer time period results in producing a smoother line. A sensitive line is more responsive in producing trade signals but at the same time traders should be wary of the greater number of false signals produced.
Positive values of the momentum lines correspond with the currency's up-trend while negative values correspond with the currency's downtrend. This is a reason why traders treat the crossing of the momentum line above or below the zero lines as buy and sell signals. The yellow circles on the graph above represent these trade signals. The crossing above the zero line results in a buy signal and a crossing below the zero line produces the signal to sell. However, it is important before making a trading decision that these crossings are consistent with the trend analysis. For example, buy positions should only be taken on crossings above the zero line if the price trend is up and sell positions should only be taken below the zero line when the price trend is down.
The momentum line also depicts the rate of change of prices. When the momentum line is positive and rising, an accelerating up trend is implied. If the line is falling but lies above the zero line, a decelerating up trend is implied. The same signals apply when the momentum line is below the zero line. However, in this case it's the downtrend that is accelerating or decelerating. Therefore, the rise and fall of the momentum line determines acceleration of the prices and the sign of the momentum line, positive or negative, relates to the direction of the trend.
Rate of Change (ROC):
The ROC closely resembles the momentum indicator, however, there are a few differences: First, the ROC's formula is based on dividing the current closing price by the price from a previous time period. Secondly, the ROC has a 100 line serving as the reference line rather than a zero line. The formula for ROC is as follows:
ROC = (P / Pn) x 100
P = Latest Closing price, N = Predetermined number of days, Pn = Closing price of n days ago.
The pictures above show that the momentum lines and the ROC lines correspondingly graph the same movements. Note the different reference points, however. The standard momentum guidelines of interpretation apply.
Stochastics:
The Stochastics indicator consists of two lines called the %K line and the %D. The formula for calculating the %K line is as follows:
%K = (P - Pn) / (Hn - Ln) x 100
P = Latest Closing price, n = Predetermined number of days, Pn = Closing price of n days ago.
Hn= Highest high for the past n days Ln= Lowest low for the past n days
The D line is the 3-day average of the K line and its importance is heavily weighted as it triggers the signals to trade. This type of Stochastics analysis is regarded as the Fast Stochastics.
Note: Some traders prefer to use slow Stochastics, which computes an additional 3-day average of the D-line. This computation produces a third line that traders use with the D-line to perform the same analysis.
The lines are plotted on a 1 to 100 scale. The formula simply measures where the closing price is in relation to the total price range for the time period selected. Chartists regard movements over 80% mark as overbought warning signals and movements below 20% as oversold signals. Some chartists use the 70% and 30% as the upper and lower warning zones. An entry into the overbought and oversold regions does not necessarily signify automatic signals to sell or buy.
Divergence between the D line and the actual prices provide additional warning signals. A bearish divergence occurs when the D line is over 80 and forms two declining peaks while prices continue to move higher. A bullish divergence arises when the D line is below 20 and forms two rising bottoms while prices continue to move lower.
The actual trade signals occur when the K line crosses the D line in the overbought or the oversold regions. Just like moving average crossovers, when the faster K line intersects the slower D line below the 20% level and moves upwards, it will be regarded as a buy signal and vice versa.
In the graph above, the sell signal is triggered when, in the overbought region, the K line (shown in green) intersects with the blue D line and moves downwards. The buy signal gets triggered in the oversold region, after the K line crosses the D line and moves upwards. Analysts recommend using Stochastics graphed over longer time periods to determine the market direction and the shorter term for daily trade signals.
In his book, Technical Analysis in the Global Currency Markets , Luca suggests using the 95% and the 5% levels for reliable bearish and bullish reversal signals. He suggests waiting for both K and D lines to turn downwards before selling and until the K and the D lines move upwards below 5% before buying.
In conclusion, all these indicators have important common attributes in enabling traders to identify buy and sell signals on the Forexnews' Charts application. Firstly, signals are most useful at the far or extreme ends of their scales. The market is considered overbought in the upper extreme and oversold in the lower extreme. Secondly, a divergence between an oscillator and actual currency movements in the extreme areas are considered important warnings and in some cases, the signals to trade. Lastly, crossing of the equilibrium line or crossings between oscillator lines generate trade signals. We will continue our discussion of the oscillators in a future tip; specifically we will look into the Moving Average Convergence Divergence (MACD) and the Relative Strength Index (RSI) indicators.
References:
· Luca,
Technical Analysis Applications in the Global Currency Markets, 1997
· Murphy,
Technical Analysis of the Financial Markets, 1999
These articles are designed to help traders understand the unique benefits of trading with DealStation. Articles contain hypothetical examples that have been created for illustration purposes only.
The opinion of the writer does not necessarily represent the view of MG and must be considered as an opinion and not fact.
