An oscillator is any object or data that oscillates between two positions.
In other words, it’s something that will constantly fall someplace between points A and B.
Consider pressing the oscillating switch on your electric fan.
Consider our technical indicators to be “on” or “off.”
An oscillator will often signify “buy” or “sell,” with the exception of cases where the oscillator is not apparent at either end of the buy/sell range.
Is this anything you’ve heard before? It should.
Oscillators include the Williams%R, Stochastic, and Relative Strength Index (RSI).
Oscillators operate on the idea that as momentum slows, fewer buyers (if in an uptrend) or sellers (if in a downturn) are prepared to trade at the current price.
A shift in momentum is frequently an indication that the present trend is weakening.
Each of these indicators is intended to suggest a potential trend reversal, indicating that the previous trend has run its course and the price is ready to reverse direction.
Consider the following two examples.
On the GBP/USD daily chart displayed below, we’ve applied all three oscillators.
Remember when we talked about how to use the Stochastic, Parabolic, and RSI indicators?
In any case, as shown on the chart, all three indicators generated buy signals near the end of December.
Taking that transaction would have resulted in a profit of roughly 400 pips. Ka-ching!
The Stochastic, Parabolic SAR, and RSI all provided sell signals during the third week of January. And, based on the subsequent 3-month decrease, you would have gained a lot of pips if you had taken that short trade.
Around mid-April, all three oscillators gave another sell signal, prompting the price to sink once again.
Now, just to show you that these signals aren’t flawless, let’s look at the same oscillators mucking up.
The indicators in the chart below may provide contradictory messages.
In mid-February, for example, the Parabolic SAR signaled a sell while the Stochastic signaled the exact opposite.
Which one should you follow?
The RSI appears to be as indecisive as you are, as it did not provide any buy or sell signals at the moment.
Looking at the chart above, it’s easy to see that there were a lot of false signals. During the second week of April, the Stochastic and RSI both produced sell signals, but the Parabolic SAR did not.
The price continued to rise from there, and you could have lost a lot of pips if you had entered a short trade right then.
If you had followed the buy signals from the Stochastic and RSI and ignored the sell signal from the Parabolic SAR, you would have suffered another loss around the middle of May.
What happened to such an impressive collection of indicators?
The answer is in the computation technique for each one.
Stochastic is based on the time period’s high-to-low range (in this case, hourly), but it does not account for variations from one hour to the next.
The Relative Strength Index (RSI) measures the difference between two closing prices.
Parabolic SAR has its own set of calculations that can add to the confusion.
That’s how oscillators work. They believe that a specific price movement will always result in the same reversal.
Of course, that’s nonsense.
While it is possible to understand why a leading signal may be incorrect, there is no way to avoid them.
If you’re getting mixed signals, it’s better to do nothing than make a “best guess.” Do not push a transaction if a chart does not fulfill all of your criteria!
Continue to the next one that meets your criteria.
Next Lesson: MACD: How to Use It to Confirm a Trend