Oscillators are a type of indicators. They are widely used in technical analysis. They can determine trend strength (momentum). Another common interpretation is related to the so-called “overbought” and “oversold” zones when oscillators can signal a potential reversal. 

For technical analysis purposes, momentum oscillators are usually located in a separate window below the price chart, which facilitates comparison between the two.

Oscillators can have an upper and lower boundary (defining extreme zones), or no boundary. In the latter case, crossing the midline is considered indicative.

Momentum indicators are a type of oscillators whose purpose is to identify the strength of the trend. In their simplest form, they compare the closing price of the current period against the closing price of the previous period (Momentum = Current Price – Previous Price). Thus, if the price of a currency pair has risen, the momentum will be positive. A decrease will result in negative momentum.

Among the most commonly used oscillators are MACD, Stochastic, RSI, ROC, CCI.

MACD (Moving Average Convergence Divergence)

This indicator is among the most used in technical analysis. Its popularity is due to its various applications – it can generate early signals for the beginning of a trend, establish the strength of that trend and indicate potential reversals.

Chart1: MACD (Moving Average Convergence Divergence). Chart: MetaTrader4

Chart 1: MACD (Moving Average Convergence Divergence). Chart generated at: Investing.com

As the name suggests, MACD is built using moving averages. The slow EMA (26 periods) is subtracted from the fast EMA (12 periods). This result is represented by the blue line on the chart, also called the MACD line. When it rises, the current sentiment is bullish. When it goes down – the current environment is bearish.

A third average, called the signal line, is a 9-period EMA on the MACD line value. When the MACD line (blue) crosses the 9-period EMA (red), momentum and potential start of a trend are established. Relatively early signals are one of the big advantages (and, as usual, a disadvantage) of this indicator.

The distance between the MACD line (fast average) and the signal line (slow average) is reflected by the histogram. Accordingly, when the fast average is higher than the slow one, the histogram will be above the horizontal zero line. The larger the difference between the two averages becomes (hence divergence), the higher bins the histogram will print. This situation confirms the presence of momentum in the bullish trend.

Identifying such situations is among the priorities of the indicator. In a downtrend, the logic is identical – the sharper the decline of the fast average compared to the slow one, the lower the histogram values will go. The momentum will be in the negative direction.

When the MACD line crosses the signal line, their values are identical. At that point, the histogram will be at zero levels.

Applications:

The chart above shows the first well-known method of interpreting averages. In the case of MACD, the averages are slightly different than usual. The MACD line is the result of the difference between two exponentials, and the signal line is EMA of that difference. But the logic behind all that moving averages calculations remains familiar. When the fast one crosses the slow one, the beginning of a movement is identified. This break is also reflected on the histogram. If each subsequent bin increases, the trend has established momentum. Further confirmation would be provided by a crossing of the zero levels by the MACD line and the signal line. When they are above the zero line, the market is bullish and vice versa – the market is bearish when they are below the zero line.

The trend will be questioned when the MACD line starts to approach the signal line (convergence). At this stage, the histogram will approach zero. At the same time, the currency pair under consideration can continue its path in the existing direction. This situation describes the so-called divergence – a period of asynchrony between the currency prices and indicator. In an uptrend, this means prices reaching new highs while the histogram marks lower ones. In a downtrend, divergence will be present when new lows in the currency pair are not accompanied by new lows in the oscillator.

This is the other key application of MACD – it warns of a possible reversal. In some cases, the trend continues for a long time, but divergence is a sign of caution and at the same time a potential opportunity.

Chart 2: MACD Divergence. Chart: MetaTrader4

Chart 2: MACD Divergence. Chart: MetaTrader4

MACD is an indicator finding applications in various trading strategies. Due to the risk of false early signals, it is better used in combination with other indicators. It is a common practice to determine the main trend with the help of a long-term moving averages (like 50 or 200 days), and then make trades only in the existing direction.

Another disadvantage (valid for momentum indicators) is that when prices enter a sideways movement, momentum slows down. A divergence may form. However, quotes often consolidate for a period of time and then continue on their way.

MACD, like all indicators, has its limitations. However, it is undoubtedly among the oscillators with extremely broad capabilities.

RSI (Relative Strength Index)

RSI is another popular momentum indicator. Its basis is the ratio between average gains and average losses over a certain time period (most often 14 periods).

RSI = 100 – (100 / (1+RS))

RS = Average Upward Price Change / Average Downward Price Change

* negative values are transformed to positive.

Thus, if in 7 of the last 14 days the average gain is 5% and in the other 7 the average loss is 1%, the relative strength (RS) will be in the ratio of 5/1. Using the above formula, RSI values ​​of 83.3 are reached. These are extremely high levels, reflecting the bulls dominance from the example data. With each subsequent day, this value will change forming the so-called RSI line (blue).

The RSI ranges from 0 to 100 with a break above 70 and below 30 considered to be entering extreme territory. In these zones, the chance of a reversal rises. Some technical analysts prefer to add a middle line with a value of 50. At these levels, relative strength is in the balance – above it the bulls control and below it – the bears.

Chart 3: RSI Momentum Indicator. Chart: MetaTrader4

Chart 3: RSI Momentum Indicator. Chart: MetaTrader4

RSI is an oscillator that finds various applications in the work of technical analysts. One of its main tasks is to account for momentum – a period in which the rate of price changes increases. Positive momentum will exist when the average profit and the number of winning days increase relative to the average loss and the number of losing days. And vice versa. This dynamic will find expression in the blue line. The RSI is particularly useful in this capacity as it identifies the relative strength of the trend.

Movements that start from the extreme zones and break the levels of 70 or 30 towards the midline are evaluated with great potential. It is considered appropriate to look for position opening opportunities around these moments. Breaking the midline of 50 is a further confirmation of the persistence of the trend. The RSI is most effective when confirming a trend that has already started, rather than as a generator of early signals.

When the trend is present, even the RSI entering the extreme zones does not mean that positions should be closed immediately or a reversal is inevitable. In fact, much of the price action can take place during these periods. However, such moments signal an increased risk, especially when divergence is present.

Chart 4: RSI Divergence. Chart: MetaTrader4

Chart 4: RSI Divergence. Chart: MetaTrader4

Like other oscillators, RSI tends to account for divergence situations – rising highs for the currency pair but falling ones for the RSI line in an upward trend; in a downward trend – new lows in prices and rising lows for the RSI line. These situations foreshadow a reversal. In practice, divergence suggests that the momentum is exhausted. The presence of divergence in the overbought/oversold areas of the oscillator portends a significant correction.

Given the fact that this oscillator manipulates price data, the methods of technical analysis can be applied directly to it. It makes sense to look for support and resistance levels (highs and lows), draw trend lines, and even identify patterns such as triangles, etc.

Chart 5: RSI Support/Resistance Lines. Chart: MetaTrader4

Chart 5: RSI Support/Resistance Lines. Chart: MetaTrader4

In the chart above, we see that the RSI reacts quickly. It has broken through its own support line, indicating a potential end to the appreciation in AUDUSD. During the decline, on the other hand, previous RSI highs have turned into successful resistances. In practice, technical analysis could be carried out in its entirety on this oscillator, but this is rather not good practice.

The RSI is an extremely popular momentum indicator due to the range of functions it performs. It follows the trend and accounts for its strength. At the same time, it signals potential reversals in the presence of divergence. It is suitable for working in different time frames.

Stochastic

Stochastic is a momentum indicator. Its main purpose is to reflect trend strength and turning points. The oscillator is limited in values from 0 to 100 with the extreme overbought/oversold areas located above 80 and below 20 respectively.  

Formula of 14-period stochastic oscillator:

%K= ((C−L14) / (H14−L14)) × 100

where:

C = Last closing price

L14 = Lowest price for the previous 14 periods

H14 = Highest price for the previous 14 periods

%K = Current value of the stochastic indicator

For example: the last closing price for EURUSD is 1.10 (C=1.10). The highest and lowest prices for the period are 1.15 (H=1.15) and 1.00 (L=1.00).

%K = ((1.10−1.00) / (1.15−1.00)) × 100

%K = 66.66

When the closing price and the highest price for the period are the same, the stochastics will be at its hundredth limit (value of 100). Conversely, if the closing price is identical to the lowest one for the period, the stochastics will be at the lowest zero levels. 

This oscillator uses two lines to produce signals. One is the fast %K line from the above example and the other is the slow %D line – the average of the %K, most commonly 3-period SMA. In this form, the stochastic oscillator is overly sensitive to price changes. A third parameter introduces a smoothing factor to clean out excess noise. So in effect the fast %K (green line) is averaged to create the %D value, which in turn is smoothed once again in order to calculate the final %D line that is on the chart (red dotted line).

Chart 6: Stochastic Indicator. Chart: MetaTrader4

Chart 6: Stochastic Indicator. Chart: MetaTrader4

Indicator settings are a matter of preference. When the parameters are low, for example 5 (%K), 3 (%D) and 3 (smoothing), the oscillator will respond quickly. Such behavior will be suitable for traders looking for early signs. Higher parameters such as 21,14,14 will present more inert indicator behavior and will be suitable for longer-term traders.

One of the main methods of using this indicator is the line crossing rule. When the fast %K breaks below or above the slow %D line, a change signal is reported. This signal will have even more value in the overbought and oversold areas where the chances of a reversal are higher. The practice in such situations is to open positions only after the breakout of the stochastic lines is followed by the extreme zones leaving. Thus, the end of the previous trend is considered confirmed.

A breakout in the downward direction (level of 80) signals entering a bear trend, and a breakout in the upward direction (level of 20) – a bull trend. The crossing of stochastic lines in the central zone between 20 and 80 is often used to optimize positions (e.g., move stops or increase position size).

Chart 7: Stochastic Lines Crossover. Chart: MetaTrader4

Chart 7: Stochastic Lines Crossover. Chart: MetaTrader4

When %K overcomes %D, there is a momentum. The further the stochastic line moves away from the signal %D line, the stronger the momentum. When the momentum starts to slow down and the two lines get closer to each other, a price reversal can be expected.

The author of the indicator, George Lane, builds his concept precisely on such observations. In an upward trend, closing prices tend to be near the highest ones for the period. In a downward trend, closing prices tend to be near the lowest ones for the period. Momentum exists and the trend is strong. There comes a stage where prices try to close above/below their previous highs/lows but fail. Accordingly, the fast line slows down. The same happens to the slow one (its average) which reacts with a delay. Stochastic lines start to converge – the momentum is lost.

It is in such situations that the more significant reversals begin and it is at these moments that the indicator very useful. Stochastic lines would cross (momentum) and leave the extreme zones, thus confirming the start of a new trend.

Another application of stochastics, as well as other momentum oscillators, are divergence signals.

Chart 8: Stochastic Divergence. Chart: MetaTrader4

Chart 8: Stochastic Divergence. Chart: MetaTrader4

During the downtrend (the first half of the chart), the stochastics has started to rise. Higher lows in the oscillator and lower lows in prices mean positive divergence.

The situation in the second half of the chart is analogous, when a negative divergence is formed. The increasingly higher highs are not in sync with the declining stochastic highs.

The stochastic indicator has been extremely popular for decades. Its ability to account for momentum and signal potential reversals are among its strengths.

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