What is Oscillator Indicator in Trading?

Trading can be challenging even for seasoned players, as factors beyond their control influence market movements. So, to make sense of this journey, traders take recourse to multiple tools that help make trading decisions easier. Technical analysis and indicators are two such tools used by both new and seasoned traders. In this article, we will take a close look at a type of indicator known as oscillators – what they are, how they work, and how they are used in trading.

What is an Oscillator?

In the world of trading, an oscillator is one of the most commonly used technical analysis indicators. An oscillator has an upper band and a lower band.

Typically, these bands remain at a distance from each other, indicating extreme values. An oscillator also has one or multiple trend indicators that oscillate or move between the upper and lower bands.

Using the trend indicators and bands, traders can identify whether a security is overbought or oversold.

Oscillators are also known as momentum indicators as they measure the speed or the rate at which the price of a security changes.

Also Raed : Best Indicators for Option Trading

How Do Oscillators Work?

An oscillator helps traders gauge whether a security is overbought or oversold by measuring the security’s momentum or the rate of price change. There are several types of oscillators that make use of different calculations.

An oscillator may take several variables in its calculations. These include the price of the security, gain or loss within a period, or moving averages. For example, here’s how the Stochastic Oscillator is calculated.

Stochastic Oscillator Formula:

%K = (C – L14/H14-L14) x 100

%K = Stochastic indicator value

C = Latest closing price

L14 = Lowest closing price in the previous 14 trading sessions.

H14 = Highest closing price in the previous 14 trading sessions.

Just like the Stochastic Oscillator, other oscillators use different formulas and factors to generate the trend indicator.

Popular Types of Oscillators

Let’s take a look at some of the commonly used oscillator indicators.

Relative Strength Index (RSI)

The RSI is a commonly used momentum oscillator that helps traders identify whether a security is overbought or oversold. The RSI is calculated by comparing the periods when the security’s price rises against the periods when the price declines. Traders often utilise the RSI along with other indicators, and it performs best in range-bound markets.

Moving Average Convergence Divergence (MACD)

The MACD is a popular momentum oscillator and is helpful in identifying trends, entry points, and exit points. The MACD is a trend-following indicator that is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.

A signal line is generated by taking the 9-period EMA of the MACD line. The MACD also has a histogram that measures the distance between the signal line and the MACD line. Traders use the MACD to spot any convergence or divergence that may act as entry or exit triggers.

Stochastic Oscillator

The Stochastic Oscillator is a momentum oscillator used to generate overbought and oversold signals with the help of the latest closing price and the highest and lowest traded prices in the past 14 trading sessions. The Stochastic Oscillator also has a 3-day simple moving average of the oscillator, which can help spot trend reversals.

Interpreting Overbought and Oversold Signals

Oscillator indicators usually have a trend indicator that oscillates within a range. Typically, the range is between 0-100 with an upper level and a lower level. When the trend indicator or oscillator crosses the upper level, the security is said to be overbought. On the other hand, if the trend line is below the lower level, the security is oversold.

Traders often exit their positions or go short when an asset is overbought and create fresh long positions or exit short positions when the asset is oversold.

For example, the RSI has an upper band of 70 and a lower band of 30. If the RSI is above 70, the asset is overbought, and the trader might exit the position expecting the price to decline. If the RSI is below 30, the asset is oversold, and the trader might purchase the asset expecting the price to increase.

Divergences and Signal Strength

At times, an oscillator and the price may move in different directions. This is known as a divergence. A divergence can help traders spot trend reversals. Traders track the price action of the security along with the indicator to spot any divergences and enter or exit positions accordingly.

For example, if the price of a security is creating lower lows while an indicator creates a higher high, it is known as a bullish divergence, and the price of the security may increase.

Traders also use additional indicators such as moving averages or another oscillator to get additional confirmation about the signal strength.

Pros vs. Limitations of Oscillators

Pros

• It can help traders spot overbought and oversold levels
• Traders can use oscillators to get entry and exit signals
• Oscillators can help spot divergences and trend reversals

Cons

• Oscillators may provide false signals in trending markets
• They are based on mathematical formulas and do not consider the fundamentals of the company
• Volatile markets might cause an oscillator to generate inaccurate signals.

Oscillators vs. Trend Indicators

Oscillators and trend indicators are commonly used tools in technical analysis. Oscillators mainly measure the rate at which the price of an asset changes and help identify whether a security is overbought or oversold.

Meanwhile, trend indicators primarily help in identifying the direction of the trend. While an oscillator indicator is suitable for range-bound markets, a trend indicator is suitable for trending markets.

Integrating Oscillators in a Trading Strategy

As a trader, it is important to have a sound trading strategy in place. Although oscillators can be useful, they are not always accurate and may generate false signals.

Traders should utilise a momentum oscillator with other indicators which help measure the direction and volatility of the security.

For example, an RSI should be used in conjunction with a moving average for direction and the Bollinger Bands indicator as a volatility indicator. It is important to know that no indicator or strategy can be accurate all the time, which highlights the importance of proper risk management.