Introduction – What’s an oscillator?
An oscillator by definition is an object which moves about in a back and forth manner between two different points. Certain indicators in the market are known as oscillators because they fluctuate around a centre point and extend their movement in between two price extreme areas.
On the AG Markets MetaTrader 4 platform, there are several oscillator indicators. Some of them are:
- Stochastics oscillator
- Relative Strength Index
- Relative Vigor Index
- Bulls Power
- Bears Power
- MACD (Moving Average Convergence Divergence)
- Commodity Channel Index
- Average True Range
- Force Index
- Moving Average of Oscillator
- Williams % Range
A look at a typical oscillator indicator window will show that each oscillator has a lower end and an upper end. This defines the range of movement for the oscillator indicator. Oscillators tend to move within a clearly defined range. Some of them move between 0 and 100, while there are some that have a range that stretches from negative to positive. The extremes of these ranges are very important areas as they indicate areas of possible price reversal. The extremes of price range within the oscillator window can either show that the market is overbought (upper range) or oversold (lower range), as seen in this snapshot below.
We can see that when the oscillator is in the overbought area, then prices begin to fall as sellers take over the market. When the price falls to an area where the market players consider it cheap to buy again, then this area will be the oversold area and buyers take over to force prices upward. This is one of the most useful plays that can be performed in the forex market with oscillators.
Trading Forex with Oscillators
There are several technical indicators which fall into the category of oscillators. However, each oscillator differs from the next as a result of the method of calculation. The trader must be very careful when choosing an oscillator to take a trade on a particular time frame.
Generally speaking, oscillators are used to trade the following scenarios in forex.
- Divergence trades
- Reversal trades at extremes of price action (overbought/oversold market conditions).
A demonstration of each of these functions of oscillators is shown below.
Several oscillators can be used for divergence trading. Divergence refers to a situation where the oscillator indicator signal lines start to take a different direction from the price action. This can be deduced by the use of trend lines which connect price highs and indicator line highs on one hand, and price lows and indicator lows on the other hand. The oscillators are leading indicators. They therefore show the future direction of price action before the price actually makes the move. So, a divergence situation will show the highs or lows of the oscillator moving in one direction, and then price following thereafter. The price correction is what presents the trading opportunity.
Reversal trades are also possible with oscillators. This is the trade that correlates directly with the nature of oscillators. Recall that oscillators shuffle from one end of the range to another. Therefore, they hit the upper end (overbought zone) and then they reverse to reach the lower end (oversold) of the trading range. Therefore, when the oscillator is at an extreme, this is a signal that price may reverse. However, two things must be made clear here. The first is that it is not automatic that prices will reverse immediately. Sometimes it may take a long time of price being overbought or oversold before a reversal occurs. It is not rare to see prices remaining at the extremes of range for days on end. Secondly, any reversal trades must be taken with sound technical basis for entry.
We display a chart below which sums up the two great ways that the oscillators can be used for trading. The oscillator used in this instance is the DeMarker indicator.
This chart encompasses both the divergence trade and the reversal trade. We see that the asset was in an uptrend and eventually the indicator line seen in the indicator window went into the overbought zone. We can also see that the indicator was overbought for several days (from December 27th to January 2nd). Eventually a technical trigger was seen in the form of a pinbar, followed by a bearish candle with a low price that is lower than the previous 6 houses. Furthermore, we also see that the price was forming higher highs when the indicator line was forming lower highs, creating a divergence scenario. So, we see a divergence and a reversal trade playing out on the same chart.
This is, in a nutshell, what oscillators serve to do in the forex market.