Technical analysis is an integral method for navigating the market. It is used to evaluate securities which involve statistical analysis of market activity, like price and volume. Charts are preferred when it comes to identifying the patterns which can help you make investment decisions.
Aside from moving averages, there are also different types of indicators when conducting technical analysis. One of which is commonly known as Oscillators.
What are Oscillators?
Oscillators are one of the indicators used in technical analysis. They are mostly used when viewing charts that are non-trending. Moving averages and trends are important when you study where the stock will go. A technician can then use oscillators when there is no definite trend shown which can help determine the stock’s direction.
An oscillator may remain at extreme levels in extended periods of time but cannot trend for a sustained period.
It’s also important to note that oscillator movements are more confined while sustained movements are limited regardless the amount of time.
Oscillators can be utilized most when monitoring companies that have stocks in either a horizontal or diagonal trading pattern. It can also prove to be beneficial on companies that have not yet established definite trend in the shifting market.
You can witness the true value of the oscillator when the stock is in an overbought or oversold condition. Oscillators are technical indicators used to measure a stock’s momentum as it wavers between the overbought and oversold zone. It will then give a buy/sell signal.
An asset is considered overbought once the oscillator reaches the upper extreme value. This means that the buying volume has been continuously deteriorating and traders will now begin selling their shares.
Conversely, if the asset’s value in the oscillator hits the lower extreme, it is deemed to be oversold. This happens when investors sell their stocks for a consistent period of time ranging from one to six months or longer.
Let’s shed a little more light on these conditions.
Overbought VS Oversold
Just like with many professions, trading involves words or terms that are hard to follow especially when you’re new. The terms overbought and oversold actually stay true to their descriptions.
These terms are highly overused in conversations regarding the market. They are used to describe opposite market situations. The terms are usually based on someone’s personal observation of price levels through the use of different indicators.
This is a term used to describe a significant and continuous upward move in price over a period of time. There is not much pullback seen in such cases. It can be clearly seen in a chart with a price movement from the lower-right to the upper-right side of the chart.
This is usually seen in situations where the demand for a certain asset unjustifiably pushes the price of an underlying asset to levels that are not supported by certain fundamentals. This takes place when an asset an asset experiences sharp upward movements over a short amount of time.
Deciding the degree in which an asset is overbought may differ between investors who are analyzing the market.
In technical analysis, it is often used to describe a situation wherein the price of a security rises to a high volume resulting to an oscillator reaching its upper boundaries.
It refers to a time period when the prices are in a position where it seems that it can no longer go any higher.
On the other hand, oversold is basically a term used to classify a trend that shows consistent downward movement in price as time passes without much pullback. This is seen in as a movement from the upper-left to the lower-right side of a chart.
An oversold asset is a term used to describe situations that are opposite of those described above.
When the price of an underlying asset falls sharply to a level lower than what it originally was, the asset is considered oversold. This mostly happens when the market overreacts or when investors are panic selling. It is also considered short term in nature.
During situations where an asset is deemed oversold, its price is expected to rebound in an event known as a price bounce.
Investors’ overreactions hold the most sway in situations that lead to an asset being oversold. When the market reacts to piece of news or other information negatively, it usually leads to excessive selling. Once such an event starts, it only spurs on more of the same.
Oversold assets are when they drop to a level where it seems that it cannot possibly go any lower.
Overbought and Oversold Indicators
It’s important to learn how to identify whether stocks are overbought or oversold especially when establishing viable trade entries. There are numerous factors that can help you in this task, some more popular than others.
Two of the most common indicators of overbought or oversold stocks are the relative strength index (RSI) and the stochastic indicators. Each measurement has their own strengths and weaknesses though they work best when used together. Other indicators include the moving average convergence/divergence (MACD) and the commodity channel index (CCI).
The stochastic indicators are range-bound oscillators. They use current price levels to compare with its range over a period of time. You should note that stocks tend to close when near their highs during an uptrend and near lows during downtrend. Thus, price action that moves further from these extremes toward the middle of the range is considered as an exhaustion of trend momentum. An example of this will be the commodity channel index (CCI).
Relative Strength Index (RSI)
Likewise, the RSI is also a range-bound oscillator. It uses average gains and losses for calculations. Its accuracy increases as the number of sessions used in the calculation rises. The strength and extent of the bullish trend will largely base on how high the RSI actually gets. A long and aggressive downtrend results in a continuously sinking RSI.
Moving Average Convergence/Divergence (MACD)
The MACD is an indicator based on trend-following momentum which shows relationships between two moving average of prices. This is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD known as the “signal line” is then placed on top of the MACD. This acts as the trigger for buy and sell signals.