The current incarnation of the futures marketplace is a digital environment conducive to enhanced pricing volatilities and low-latency trade executions. In such a dynamic atmosphere, a method of interpreting price action on-the-fly is a necessity. As a result, technical analysis, a study of price itself, has become the go-to reference in crafting astute trading decisions.
One of the most popular types of technical indicators is an oscillator. An oscillator applies mathematical formulas directly to price action to determine future market behavior. This task is accomplished through actively quantifying the strength of current pricing momentum and determining whether a security is being actively overbought or oversold.
Types of Oscillators
Oscillators are broken into two basic groups, each with a unique application and function:
Centered Oscillators
Centered oscillators measure pricing momentum through rotating above and below a centralized baseline. In simplest terms, if an oscillator is above its baseline then momentum is positive; if below, momentum is negative. Centered oscillators are particularly useful in determining the relative strength or weakness of a trend and identifying potential breakouts.
Moving Average Convergence Divergence (MACD) is a popular centered oscillator because it fluctuates above and below an established baseline of zero.
Source: Futures Source
Banded Oscillators
In order to determine whether a security is presently overbought or oversold, banded oscillators establish fixed or variable upper and lower bands. As the oscillator approaches the upper band, the security is becoming overbought — and conversely oversold when nearing the lower band. Banded oscillators are particularly useful in reversal and range trading strategies because they give a concrete level as reference for lagging momentum and a potential change in price direction. The Relative Strength Indicator (RSI) is a frequently used banded oscillator that examines price on a fixed scale between zero and 100.
Source: Futures Source
Tracking an oscillator in real-time is a relatively straightforward task. Technology has seamlessly integrated mathematical computation into a user-friendly interface. For instance, when using the MACD or RSI, important levels are calculated and visually represented automatically. If the MACD of a security is in positive territory, it is graphed and visible above the baseline; if the RSI is dramatically negative, it is in clear proximity to the lower band of zero.
Interpretation and Trade
An oscillator is a derivative study, meaning its results are based upon an external factor, price action. It is the scrutiny of price itself that a signal for market entry is created or insight into active trade management is gained. Understanding that the primary goal of an oscillator is to quantify the momentum driving price is a key aspect of successfully incorporating the tool into a trading plan.
Here are a few concepts relevant to oscillators that many traders use when tailoring market entry and exit decisions:
Extremes
As in banded oscillators, when values approach established upper-bound and lower-bound levels, pricing momentum may be prone to stagnate or reverse direction. This phenomenon is often seen as a signal to exit an open position or consider entering the market in a counter-trend fashion.
Source: Futures Source
Crossover
Crossover strategies typically apply to centered oscillators, as values cross over and under the established baseline. A crossover point may indicate growing bullish or bearish strength in pricing momentum, a possible signal of a potential breakout. Crossovers also pertain to the concurrent use of multiple oscillators, creating a signal for market entry or exit upon their intersection.
Source: Futures Source
Divergence
Divergence is present when price and a chosen oscillator begin to move in opposite directions. Divergence may be either positive or negative, and traders often viewed it as the exhaustion of a trend or pending change in market direction. Positive divergence occurs when the value of an oscillator increases while price decreases, and negative divergence arises in a case of increasing price in the face of a weakening indicator. In each instance, traders can use divergence as a signal to either enter or exit a market based upon changes in pricing momentum.
Source: Futures Source
Keep in mind that oscillators are only one kind of technical indicator able to provide insight into market behavior. Although they may be effective in quantifying current pricing momentum, when implemented in isolation, they are capable of leading traders astray. Whipsaw, consolidating, or explosively trending markets often create an abundance of “false” signals, queuing costly trading decisions.
Oscillators are best used in conjunction with other technical indicators, as well as being accompanied by an extensive understanding of market fundamentals. Within the context of a comprehensive trading plan, the use of oscillators can be a valued tool for achieving profitability in the marketplace.
