ASX Charting Course

Chapter 23

Oscillators

There is a rhythm to how the market moves and this can be revealed using an oscillator study. There are many studies that appear to oscillate, but the study commonly known as the oscillator is derived by computing the difference between two moving averages of different periods.

Oscillator = Moving Average (A) – Moving Average (B)

- where A is the first, short period moving average

B is the second, longer period moving average

The oscillator is plotted as a single line usually below the bar chart. It oscillates about the zero line as the market moves from bullish to bearish. It is an unbounded indicator, so it has no upper or lower limits and this should be taken into account when using the study as an overbought / oversold indicator.

The zero line is the common reference and that is the point where the two moving averages cross. Movement away from this line to the higher side indicates the shorter moving average crossing above the longer moving average. In this situation the two averages are diverging, which is the result of price moving higher, in this case.

Conversely a move below the zero line is the result of the short moving average crossing below the longer moving average and that is a product of price moving lower. It is also an indication that price will continue to move lower.

The peaks made by the indicator, both low and high, are the result of the culmination of a vertical price movement. Once the curve has peaked and heads back to the zero line, it reflects the two moving averages converging, which will probably produce a change in the recent trend.

How to use

There are several ways you can use this indicator. It really depends on your own individual style of trading. which technique you chose to apply. The most obvious technique is to use the signal generated by the oscillator when it crosses the zero line. A buy signal is generated when the oscillator crosses above the zero line and a sell signal is generated when the indicator crosses below the zero line.

Another technique is to act just after the indicator has peaked, high or low. That is, to sell a turn in the indictor above the zero line and the buy a turn below the line. It can be useful to qualify this with an oversold or overbought region, using previous peaks to determine those levels. This is one of the advantages of the oscillator over just watching moving averages. It's difficult to perceive a peak in divergence while only watching the moving averages.

The oscillator can be filtered yet again by using an average on the indicator to detect major changes in its behaviour. This is the basis of oscillator less Moving Average study. Moving Average Convergence Divergence (MACD) is a specific type of oscillator, which plots a trailing moving average.

Fig 32 © Copyright 2003 CQG, Inc. All rights reserved worldwide

In the example above the moving averages have been plotted over the bar chart to enable a clear picture of how that relates to the oscillator. Notice how deceptive the moving averages are with respect to the peaks. The overbought / oversold levels show up as a result of previous peak
performance at +100 and -100.