Mastering Oscillators: Tools for Identifying Momentum and Reversals
Oscillators are widely used in technical analysis to determine trend strength (momentum). They also help identify “overbought” and “oversold” zones, which can signal potential reversals.
Momentum oscillators are designed to identify the strength of a trend. In their simplest form, they compare the current period’s closing price against the previous period’s closing price:
Momentum = Current Price − Previous Price
If the price of a currency pair has risen, the momentum will be positive. Conversely, a price decrease will result in negative momentum.
Oscillators can have an upper and lower boundary (defining extreme zones) or no boundary. In the latter case, crossing the midline (median value) is indicative.
The most used oscillators include MACD, Stochastic, RSI, ROC, and CCI.
MACD (Moving Average Convergence Divergence)
Due to its versatility, the MACD is one of the most widely used oscillators in technical analysis. It can generate early signals for the beginning of a trend, establish the trend’s strength, and indicate potential reversals.
For technical analysis purposes, oscillators are usually displayed in a separate window below the price chart.
Chart 1: MACD (Moving Average Convergence Divergence). Source: Investing.com
As the name suggests, MACD is built using moving averages. The slow (26 periods) exponential moving average (EMA) is subtracted from the fast EMA (12 periods). The blue line on the chart, also called the MACD line, represents this result. When this line rises, the current sentiment is bullish. When it falls, the current environment is bearish.
A third average, called the signal line, is a 9-period EMA of the MACD line. When the MACD line (blue) crosses the signal line (red), it indicates momentum and the potential start of a trend. Early signals are one of this indicator’s significant advantages. However, many false signals will also be produced.
The histogram reflects the distance between the MACD line and the signal line. When the MACD line exceeds the signal line, the histogram will be above the horizontal zero line. The more significant the difference between the two lines (divergence), the higher the histogram bars. The increasing histogram confirms momentum in a bullish trend.
In a downtrend, the interpretation is identical—the sharper the decline of the MACD line compared to the signal line, the lower the histogram values. In this case, the momentum will be to the downside.
The histogram will be at zero levels when the MACD line and the signal line values are identical.
Applications of MACD
The calculation of MACD averages follows a slightly different approach than the usual MA calculations. The MACD line results from the difference between two exponential averages, and the signal line is an EMA of that difference.
However, the traditional approach of moving average analysis can be applied. When the fast average (MACD line) crosses over the slow average (signal line), it signals the beginning of an uptrend. The histogram also reflects this crossover, going from negative to positive values. If each subsequent histogram bin increases, the trend has established momentum. Further confirmation is provided if the MACD and signal lines cross over the horizontal zero level. The market is bullish when the lines are above the zero level.
Similarly, a downtrend may begin when the fast average (MACD line) crosses under the slow average (signal line). If each subsequent histogram bin decreases, the trend has established momentum to the downside. Additional downtrend confirmation will be provided if the MACD and signal lines cross under the horizontal zero level. The market is bearish when the lines are below the zero level.
When the MACD line converges with the signal line, the histogram approaches the zero line, signaling a potential change in direction.
Oscillators are good at identifying divergence—a period of asynchrony between currency prices and indicator values. In an uptrend, divergence occurs when prices reach new highs while the histogram values decrease. In a downtrend, divergence occurs when bottoms are not confirmed by lower lows in the oscillator.
The trend will often continue in the existing direction for a long time, but divergence is a sign of possible reversal.
Chart 2: MACD Divergence. Source: MetaTrader4
MACD is an indicator that finds applications in various trading strategies. However, due to the risk of false early signals, it is better used with other indicators. It is common practice to determine the primary trend with the help of long-term moving averages (like 50-period or 200-period daily SMA) and then make trades only in that direction.
Another disadvantage common to momentum indicators is that momentum slows down when prices move sideways. A divergence may form during this period. However, prices often consolidate and then resume the primary trend.
Like all indicators, MACD has its limitations, but it is undoubtedly among the oscillators with the most extensive capabilities.
RSI (Relative Strength Index)
RSI is another popular momentum indicator. It is based on the ratio between average gains and average losses over a specific period, most often 14 periods.
The formula for RSI is:
\text{RSI} = 100 – \left(\frac{100}{1 + \text{RS}}\right) \\
\]
Where:
- RS (Relative Strength) is calculated as:
RS = \frac{\text{Average Upward Price Change}}{\text{Average Downward Price Change}}
\]
*Only positive (absolute) values.
For example, if the average gain in seven of the last 14 days is 5% and the average loss for the other seven days is 1%, the RS will be 5/1. Using the above formula, we find an RSI value of 83.3. This value will change each subsequent day, forming the so-called RSI line (blue).
The RSI ranges from 0 to 100, with values above 70 and below 30 considered extreme. The probability of a reversal in these zones (from 70 to 100 and 0 to 30) rises. Some technical analysts prefer to add a middle line with a value of 50. At 50, the relative strength is balanced. Above it, the bulls are in control, and below it, the bears dominate.
Chart 3: RSI Momentum Indicator. Source: MetaTrader4
RSI is an oscillator that has various applications in technical analysis. 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 increase relative to the average loss, and vice versa. This dynamic will be reflected in the blue line.
Movements that start from the extreme zones and break the levels of 70 or 30 towards the midline are evaluated as pivotal for the trend.
The RSI is most effective when confirming a trend already started rather than as an early signals generator.
RSI entering the extreme zones does not mean a trend reversal is inevitable. Much of the price action can take place during these periods. However, such moments signal an increased probability of correction, especially when divergence is present.
Chart 4: RSI Divergence. Source: MetaTrader4
Like other oscillators, RSI accounts for divergence—rising highs for the currency pair but falling highs for the RSI line in an upward trend; new lows in prices, and rising lows for the RSI line in a downward trend. These situations foreshadow a reversal. Divergence suggests that the momentum is exhausted. The presence of divergence in the overbought/oversold areas of the oscillator portends a significant correction.
Sometimes, technical analysts find it appropriate to perform their analysis directly on the RSI. It makes sense to look for support and resistance levels (highs and lows), draw trend lines, and even identify patterns such as triangles.
Chart 5: RSI Support/Resistance Lines. Source: MetaTrader4
In the chart above, we see that the RSI reacts quickly. It has broken its own support line, indicating a potential end to the appreciation in AUDUSD. During the decline of the pair, on the other hand, previous RSI highs have turned into successful resistances. Technical analysis could be carried out in its entirety on this oscillator, but this approach is not recommended.
Due to its range of applications, the RSI is a viral momentum indicator. It follows the trend and accounts for its strength. At the same time, it signals potential reversals. RSI works well in different time frames.
Stochastic Oscillator
The stochastic oscillator is primarily used to reflect trend strength and identify turning points. The oscillator ranges from 0 to 100, with extreme overbought/oversold areas above 80 and below 20, respectively.
Formula of 14-period Stochastic Oscillator:
\%K = \left( \frac{C – L_{14}}{H_{14} – L_{14}} \right) \times 100 \\
\]
Where:
- C: Last closing price
- L14: Lowest price for the previous 14 periods
- H14: Highest price for the last 14 periods
- %K: Current value of the stochastic indicator
For example, if the last closing price for EURUSD is 1.10 (C=1.10), and the highest and lowest prices for the period are 1.15 (H=1.15) and 1.00 (L=1.00), respectively:
\%K = \left( \frac{1.10 – 1.00}{1.15 – 1.00} \right) \times 100 = 66.66
\]
When the closing and the highest prices are the same, the stochastic will be at its upper limit (value of 100). Conversely, if the closing price is identical to the lowest one, the stochastic will be at the lowest level (value of 0).
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, which is an average of the %K (most commonly SMA). In this form, the stochastic oscillator is overly sensitive to price changes. A third parameter introduces a smoothing factor to filter out excess noise. So, in effect, the fast %K (green line) is averaged to create the %D values, which is then smoothed once again to calculate the final %D line represented on the chart (red dotted line).
Chart 6: Stochastic Indicator. Source: MetaTrader4
Indicator settings are a matter of preference. When the parameter values are low, for example, %K (5), %D (3), and smoothing (3), the oscillator will respond quickly to price changes. Such behavior is suitable for traders looking for early triggers. Higher parameters (such as 21, 14, 14) will present more inert indicator behavior, which long-term traders prefer. The sensitivity to the two different indicator settings is evident in Chart 6.
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. This signal will be more significant when generated inside the overbought and oversold areas, where the chances of a trend reversal are higher. If prices leave the extreme zone, the previous trend’s end is confirmed, and a new one might be starting.
A breakout in the downward direction (breaking the level of 80 to the downside) signals entering a bear trend, and a breakout in the upward direction (breaking the level of 20 to the upside) signals the start of a bull trend.
Crossing 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. Source: MetaTrader4
When %K overcomes %D, there is momentum. The further the stochastic line moves away from the signal %D line, the stronger the momentum. A price reversal can be expected when the momentum slows down, and the two lines get closer.
The indicator’s author, George Lane, builds his concept precisely on such observations. In an upward trend, momentum exists when closing prices tend to be near the highest price for the period. In a downward trend, momentum exists when closing prices tend to be near the lowest price for the period. At some point, 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, which reacts to price changes with a lag. Stochastic lines start to converge – the momentum is lost.
Similarly to other momentum oscillators, Stochastics can signal divergence.
Chart 8: Stochastic Divergence. Source: MetaTrader4
The Stochastics began to rise during the downtrend (the first half of the chart). Higher lows in the oscillator and lower lows in prices indicate positive divergence. In the second half of the chart, a negative divergence occurred, where increasingly higher prices were not in sync with declining stochastic highs.
The stochastic indicator has been popular for decades due to its ability to account for momentum and signal potential reversals.
Conclusion
Oscillators are used in technical analysis to identify trends early, assess their strength, and pinpoint potential reversal points. Due to the high number of false signals, these indicators should be used in conjunction with other analytical tools for a more comprehensive analysis.
