Chart-Formations.com

Oscillators are usually leading indicators that are most useful in analyzing securities or equities that are trading in a range, i.e., non-trending but can also be used to identify when the potential for a trend reversal has increased. Thus, oscillators are most beneficial when a security is in a horizontal trading pattern. Oscillators move higher and lower between overbought or oversold conditions and indicate potential turning points for a security as overbought and oversold conditions would, respectively, equate with find unsustainable levels of optimism and pessimism for the underlying security. In addition, oscillators tend to be leading indicators, which is also the reason why they are not as useful in a trending market, as they turn before the price does.

There are several oscillating indicators that can be used to analyze non-trending securities with the Stochastic Oscillator being one of the most popular. Other oscillators include Relative Strength Index (RSI), Rate of Change (RoC), Williams' %R, and others. Each oscillator has a set of reference points that will generate entry and exit signals when the price action deviates too much from its normal range.

Oscillator Period

Shortening the period for an oscillator is generally preferred over increasing it. A shorter period oscillator will be more sensitive to price changes and will signal turning points earlier as the price action develops on the chart. Also, as oscillators are said to be leading indicators, they often change direction before the price reverses its trend, a phenomena referred to as divergence. As a result, oscillators should not be used immediately when they turn to generate entry signals, especially when the underlying security is still in a seemingly strong trend.

Reference Lines

Most oscillators have set reference lines to indicate the overbought and oversold areas. However, for some unbound oscillators you need to determine the upper and lower extremes over a relatively long period and draw the reference lines so that the oscillator only spends about 5% of the time beyond the reference lines. These reference lines should be adjusted on a regular basis. Some traders draw their own reference lines for oscillators that have predefined reference lines, such as the 30 and 70 lines of the RSI.