Oscillator Indicators Part II
Oscillator Indicators can provide useful insights by alerting traders of short-term market extremes commonly referred to as overbought and oversold conditions. In many cases, these extremes signal warnings or produce actual signals to trade. Forexnews'
Charts & News software offers a mix of oscillator indicators such as the
Momentum and
Rate of Change, while also offering more sophisticated indicators such as the
Relative Strength Index (RSI),
Moving Average Convergence/Divergence (MACD), and
Stochastics.
This article will be the continuation of the
Oscillator Indicators article, in which we discussed the basic oscillator analysis. This piece will focus on the
Relative Strength Index (RSI) and the
Moving Average Convergence Divergence (MACD) indicator.
Relative Strength Index (RSI):
The RSI measures the relative changes between the higher and lower closing prices, and it is plotted on a 0 to 100 scale. The formulas for calculating the RSI are:
RSI=100-(100/1+RS)
RS = (Average of n days' closes up) / (Average of n days' closes down)
n= Predetermined number of days
The average up value can be found by adding the total points gained on up days during the n days and dividing the total by
'n'. To find the average down value, add the total number of points lost during the down days and divide the total by
'n'.
The 70% and 30% levels are considered warning signals, with movements over 70 are considered overbought and movements under 30 are considered oversold. The trading signals originate when divergence occurs between the RSI and the actual price followed by a double top or a double bottom formation. In the
double top formation, the first top is formed at or above the 70% level and a lower second top at or below the 70% level. The signal to sell is triggered when RSI dips through the first trough.
The
double bottom formation takes place when a rising trough above the 30% level follows the first trough, which is at or below the 30% level. The signal to buy is triggered when the RSI breaks through the first top. Author Cornelius Luca points out that some analysts prefer to use only numerical values. They consider values above 90% as the sell signal and values below 10% reflect a buy signal.
In the picture above, the yellow circles signify buy and sell signals. The sell opportunities arise after a double top formation and the buy signal is triggered by a double bottom formation. It is important that these signals are consistent with the trend.
The buy signal (shown in blue) occurred as the currency dropped below the 5% level, despite the fact that it opposed the trend. This would not be considered a strong indication to buy, as there was little consistency with the trend. As you can see, USD/JPY continued to move downwards.
Moving Averages Convergence Divergence (MACD):
As per
Charts & News software, the MACD line defaults to the difference between 12-day and a 26-day moving averages. These MAs are plotted on an open scale around the zero line. The formula for the MACD is as follows:
MACD = EMA12-EMA26
EMA12 = 12-day exponentially smoothed moving average
EMA26 = 26-day exponentially smoothed moving average
When the 12-day moving average is greater than 26-day average, the MACD line is positive and vice versa. In addition to the MACD line, the charts are defaulted so that a 9-day moving average of the MACD line serves as the
Signal line.
The MACD line is very useful as it combines oscillator analysis with trend analysis by using the principles of the double moving average crossover. Therefore, the actual trade signal arises when the MACD and the Signal line cross. A buy signal is triggered when the faster MACD line crosses the slower Signal line and moves upwards. When the MACD line moves downwards after crossing the Signal line, a sell signal is generated.
Crossings above and below the zero line produce additional trade signals. Again, just like the momentum indicator, a crossing above the zero line is considered a buy signal and movements below the zero line are treated as a sell signal. Lastly, divergence between the MACD line and the actual prices trigger warning and/or trade signals. A bearish divergence occurs when the MACD line is well above the zero line and starts to move down while the prices continue to trend upwards. When the currency continues to dip downwards, while the MACD line starts to head up from far below the zero line, a bullish divergence is implied.
The MACD line does not have any upper and lower limits like the RSI or the Stochastics indicators. A very good way to judge whether a MACD line is far below or far above is by visual inspection.
In the graph above, the green circles show buy and sell signals due to crossings of the yellow MACD line and the purple Signal line. The blue circles show the buy and sell signals as a result of the MACD line crossing the zero line. These trading signals can be considered strong as they are consistent with the trend and at the same time occur far below and far above the zero line.
In conclusion, it is important to remember a few things about the Oscillator indicators. Firstly, oscillators should always be used as trading signals when they are consistent with the trend. Therefore, the concept is to buy in an oversold condition during an uptrend and sell in an overbought condition during a downtrend. Oscillator analysis should be used to complement the trend analysis and not to substitute for it. Secondly, due to the nature of oscillators, there are times when they are more useful than at others. For example, oscillators should not be used at the beginning of important moves; however, they do serve as better tools to predict the end of a prevalent trend.
References:
� Luca,
Technical Analysis Applications in the Global Currency Markets, 1997
� Murphy,
Technical Analysis of the Financial Markets, 1999
These articles are designed to help traders understand the unique benefits of trading with DealStation. Articles contain hypothetical examples that have been created for illustration purposes only.
The opinion of the writer does not necessarily represent the view of MG and must be considered as an opinion and not fact.
