Oscillators are indicators that are used when viewing charts that are non-trending. Moving averages (MA) and trends are paramount when studying the direction of a stock. A technician will use oscillators when the charts are not showing a definite trend in either direction. Oscillators are thus most beneficial when a company's stock either is in a horizontal or sideways trading pattern, or has not been able to establish a definite trend in a choppy market.

When the stock is in either an overbought or oversold situation, the true value of the oscillator is exposed. With oscillators a chartist can see when the stock is running out of steam on the upside, the point at which the stock moves into an overbought situation. This simply means that the buying volume has been diminishing for a number of trading days which means traders will then start to sell their shares. Conversely, when a stock has been sold by a greater number of investors for a consistent period of time ranging from one to six months or longer, the stock will enter an oversold situation. (For related reading, see The Basics of Money Flow.)

The Relative Strength Index
In the example below, you can see Microsoft's (Nasdaq:MSFT) lower range of the relative strength index (RSI) is 30 and the upper range is 70. The midrange is 50. We now understand that the RSI becomes oversold at the 30 level and overbought at the 70 level. Some charts and theories would use 20/80 as the low/high boundary. For some technicians, these numbers may be far too conservative, causing the trader to be too late on the buy side and therefore miss out on capital gains. Also, if traders use the 80 high mark, they may miss the true selling point on the overbought side.

Arrows are shown at the entry points at which the RSI bounces off the 30 level. By drawing a horizontal channel between the $66 and $72 price levels, we have marked the horizontal trading pattern. Notice that the RSI tends to remain well above 50 while the price action is inside this horizontal channel. Here the RSI shows a somewhat overbought situation, but no major selling pressure is evident. Many investors believe Microsoft can be purchased at any level because they will hold it in their portfolios for the long-term and are not concerned with trading it short-term. (To learn more about RSI, see Ride The RSI Rollercoaster.)

msft.gif
Source: TradeStation

J. Welles Wilder, Jr. developed the RSI and first shared it with the technical community in his book "New Concepts in Technical Trading Systems." It's a must read for anyone planning to use oscillators to determine buy and sell points.

Bottom Line
You will begin to notice that one indicator looks very similar to others and using one indicator in conjunction with another is a very useful tool for determining the important entry/exit points. Using this indicator you can see how professional traders can be in and out of stocks long before the average investor, and you will also be able to find a comfortable trading range.

Related Articles
  1. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  2. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
  3. Technical Indicators

    Using Moving Averages To Trade The Volatility Index (VIX)

    VIX moving averages smooth out the natural choppiness of the indicator, letting traders and market timers access reliable sentiment and volatility data.
  4. Chart Advisor

    Traders Step Back to Assess Commodities Damage

    Traders are turning to these exchange-traded notes and exchange-traded funds to analyze key commodities and determine what could be coming next.
  5. Chart Advisor

    Strategizing for a Market Fall...or Rally

    The downtrend isn't confirmed yet, so be prepared with trades for whether the stock market rallies or continues to fall. Here's how to do it.
  6. Trading Strategies

    Are You a Trend Trader or a Swing Trader?

    Swing traders and trend traders execute market timing strategies that require different skill sets.
  7. Technical Indicators

    Detrended Price Oscillator Trading Strategies

    The detrended price oscillator (DPO) offers a simple approach to cycle analysis, removing momentum and long-term trends from the equation.
  8. Investing

    Using Fibonacci to Analyze Gold

    Use Fibonacci studies to analyze gold by picking out hidden harmonic levels that can provide major support or resistance.
  9. Investing

    Predictions For The Stock Market

    Learn different choices and strategies that can be used to create a profit regardless of what direction the market is going.
  10. Chart Advisor

    Real Estate Investment Trust ETFs Offer Stability

    Risk-averse traders are turning to real estate investment trusts. We'll look at a popular real estate investment trust ETF and few of its top holdings.
RELATED TERMS
  1. Fintech

    Fintech is a portmanteau of financial technology that describes ...
  2. Indicator

    Indicators are statistics used to measure current conditions ...
  3. Intraday Momentum Index (IMI)

    A technical indicator that combines aspects of candlestick analysis ...
  4. Mass Index

    A form of technical analysis that looks at the range between ...
  5. Money Flow Index - MFI

    A momentum indicator that uses a stock’s price and volume to ...
  6. On-Balance Volume (OBV)

    A momentum indicator that uses volume flow to predict changes ...
RELATED FAQS
  1. What are common strategies traders implement when identifying a Bullish Homing Pigeon?

    The bullish homing pigeon is a candlestick formation that occurs when a long black candlestick is followed by a shorter black ... Read Full Answer >>
  2. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  3. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  4. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>
  5. What are the alert zones in a Fibonacci retracement?

    The most commonly used Fibonacci retracement alert levels are at 38.2% and 61.8%. A 50% retracement level is also commonly ... Read Full Answer >>
  6. How was the Fibonacci retracement developed for use in finance?

    The use of Fibonacci retracements in stock trading was popularized by noted technical analysts W.D. Gann and R.N. Elliott. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!