Oscillator

The term “oscillator”, in technical analysis, refers to a specifically calculated indicator fluctuating within a range between two levels or around a line. There are usually two extremities considered to be the levels within which the oscillator value moves during a period of time, most of the time staying withing the bounds, but sometimes crossing them. Those cases of crossing are interpreted by technical analysts as possible buy or sell signals, as they often indicate periods of a security being overbought (when the higher level is reached or crossed) or oversold (when the lower level is reached). 

Oscillators are generally believed to be useful tools for analysis, and a skilled broker is expected to know how to use such indicators. Nevertheless, no single oscillator can provide a fully truthful picture of upcoming events. It’s good for detecting possible changes or periods when the assets are oversold and overbought, but there are no guarantees a change would actually occur, so it’s highly recommended to use oscillators, but also combine it with other tools for analysis.

Oscillator main types

There are two main varieties of oscillators used in technical analysis:

• Centered oscillators, which move up and down around a line;
• Banded oscillators, which move between a pair of levels.

Centered oscillators are frequently used for detecting the general move of a security price. To be precise, when a centered oscillator moves below the center line, it indicates a bearish momentum, while moving above the line indicates a bullish momentum. The most popular centered oscillators are MACD (which stands for Moving Average Convergence/Divergence) and ROC (which stands for Rate-Of-Change).

Banded oscillators fluctuate between, above and below two bands representing the maximum and minimum of price values, as their name indicates. Such oscillators are employed for noticing and identifying overbought and oversold conditions of a certain security on the market. Banded oscillators are generally recommended to be used for analysis of sideways markets. The most often used types of banded oscillators are RSI (meaning the Relative Strength Index) and the Stochastic Oscillator. 

Oscillator working principles

For better understanding how an oscillator works, let’s examine a banded oscillator. Firstly, it’s required to determine and set the highest and lowest levels, which are the extremities for an oscillator. Those values generally depend on the chosen oscillator and changes rather mildly from security to security. Then the oscillator values over time are calculated, and an indicator describing the trend is created and depicted in a form of a chart. 

When an indicator moves closer to the higher level, especially if it crosses the line, it serves as a sign that the security is in overbought condition, which might be interpreted as a signal to sell the security, as the price is expected to drop soon. Similarly, if an oscillator nears the lower level, it indicates that the security is oversold, and again it might be supposed to be a reason to buy it.

In finance, oscillators are usually measured in percentage, with various price measures being used for calculation (with closing price being the most popular one, usually considered in relation to the total price range). There are different ways to gauge the indicators for different oscillators, and an important notion is that banded oscillators usually require more complicated calculations.

When the oscillator reflecting price fluctuations is finally depicted in a chart form, it’s commonly accepted that the indicator rising above 70% (in some cases 80%) signifies an overbought condition. An oversold condition is observed when the indicator crosses the level of 30% (sometimes 20%).

The abovementioned situations are true in case the price stays in a previously determined range. If it changes significantly, with the values being much higher or lower than the range, the oscillator signals might be ambiguous or outright deceiving.

Risks involved with Oscillators

As oscillators were created for detecting situations only, the interpretation of their measurements is highly subjective. The indicators shouldn’t be perceived as strict orders to buy or sell, instead of it they simply show notable possibilities of change. Forecasting the market situation is a complex process, and to minimize risks, investors and brokers don’t usually use oscillators only, also taking into consideration other tools for analysis, as well as a variety of indicators and external factors.

Oscillators provide a good possibility for predicting price changes, but at the same time higher risks are involved. Imagine a situation when a trader believes a security is in oversold condition by considering early signals received from analyzing an oscillator (without taking into account any other factors). It might turn out that the prediction wasn’t correct, the security price continues its decrease, so the trader suffers a loss.

To avoid such situations, it’s necessary to analyze a variety of factors together. Using more than one oscillator combined with observing other market conditions and employing several tools for analysis might be a good strategy.