Oscillators are momentum indicators that identify periods when an asset is overbought and oversold. It’s easy to recognize oscillators, as they are placed below a price chart and move within a particular range. Oscillators are believed to be highly reliable tools.
Interestingly, there is a disagreement between those who support technical analysis and fundamental analysis. For instance, in 2007, Irwin and Park issued a review claiming that 56 of 95 modern studies confirm that technical analysis provides positive results. Still, many of the positive results were questionable due to issues with data tracking. However, only by practicing can you make your own conclusions.
Relative strength index
The relative strength index, or RSI, is an oscillator that determines whether an asset is overbought or oversold, provides exact entry and exit points, and signals trend reversals.
The indicator has only one setting — period. The standard period is 14. It can be reduced when applying the RSI to low timeframes and increased when trading on higher timeframes.
The indicator consists of one line that moves within a 0-100 range. Its key levels are 30 and 70. When the RSI rises above 70, an asset is overbought, so the market may turn down soon. When the RSI is below 30, an asset is oversold, so its price may rise soon.
Traders should remember that a trend reversal is confirmed only when the oscillator leaves the overbought/oversold zone. Also, they should be cautious and confirm RSI signals because the indicator may return to zones several times before the market reverses.
A divergence is a strong signal occurring when an oscillator doesn’t confirm a price movement. There are bullish and bearish signals. The picture below shows the general rules.
Hidden divergences provide weaker signals but can be used if confirmed by other indicators or patterns.
A stochastic oscillator is an indicator that resembles the RSI as it moves within a 0-100 range and provides similar signals. However, the RSI is more effective in a trending market, while Stochastic is more applicable in consolidating markets.
The stochastic oscillator consists of two lines: the %K line and its moving average %D line. Stochastic’s key parameters are 14 and 3, where 14 stands for a period of the %K line (fast stochastic) and 3 is a period of the %D line.
Divergence signals are the same as for the RSI indicator.
Like the RSI, the stochastic oscillator reflects conditions in which an asset’s price is too high or too low. Stochastic’s key levels are 20 and 80. When the oscillator is below 20, an asset is oversold, and the price may rise soon. When the oscillator is above 80, the price may fall quickly as an asset is overbought.
You can also use line crossovers to catch buy and sell signals. When the %K line falls below the %D line above 80, it’s a sell signal. When the %K line rises above the %D line below 20, it’s a buy signal.
There are numerous oscillators, and there is no perfect one that would suit any strategy. You should select the one that will fit your approach. If you are a newbie trader and haven’t chosen an indicator, you could start with the relative strength index and Stochastic.