When big investors are buying a stock, and are doing so aggressively, their demand should yield higher prices in the future, making the stock a wise investment.
In some respects, this is nothing more than Markets 101: examining supply and demand. Since price is a function of demand, it seems counter-intuitive to track fluctuations in one element without paying attention to the other. This is where the Chaikin Oscillator comes in, examining both closing price and buying and selling pressure to determine the underlying demand for a stock.
The Chaikin Oscillator was invented by Marc Chaikin, a long-time stock trader and analyst who has created dozens of indicators during his distinguished career, with many of them now staples of Wall Street technical analysis. He devised the oscillator indicator as a way to measure accumulation or distribution of a security by institutional investors, the ones who move markets.
- The Chaikin Oscillator examines both the strength of price moves and underlying buying and selling pressure to provide a reading of the demand for a security, and possible turning points in the price.
- Divergence between price and the Chaikin Oscillator is the indicator’s most frequent signal, and often flags a short-term reversal in price.
How the Chaikin Oscillator Works
The Chaikin Oscillator is essentially a momentum indicator, but of the Accumulation-Distribution line rather than merely price. It looks at both the strength of price moves and the underlying buying and selling pressure during a given time period.
A Chaikin Oscillator reading above zero indicates net buying pressure, while one below zero registers net selling pressure. Divergence between the indicator and pure price moves are the most common signals from the indicator, and often flag market turning points.
Chaikin Oscillator Construction
The transition from MACD to Chaikin Oscillator requires several steps. The Chaikin Oscillator was created in reference to the accumulation/distribution, another Chaikin brainchild. The acc/dis line builds on the money flow multiplier, which attempts to quantify the amount of money coming into the market and its impact on stock prices.
The multiplier formula is as follows: f=(High− Low)[(Close− Low)−(High− Close)]
Lets say the stock in the previous example peaked at $25 during the look back period and then fell to $21. A day later, it closed at $22. The money flow multiplier in this case would be (25−21)[(22−21)−(25−22)]=−.5
Multiply that number by the quantity of stock traded over the period to get money flow volume, while the running total generates the acc/dis line. The final step is to apply this output to MACD.
What the oscillator lacks in simplicity, it makes up for in authority. By measuring the momentum of the accumulation/distribution line using the MACD model, the oscillator should anticipate when the line will change direction. By now, we're several levels removed from the stock price, but Chaikin devotees argue that the distance is needed to determine the importance of volume and price changes.
Also, three- and 10-day values aren't locked in stone. For example, swapping in six- and 20-day EMAs will result in a Chaikin Oscillator that changes direction less abruptly.
The Bottom Line
The Chaikin Oscillator generates technical output that supports sound buy or sell decisions but is best used in conjunction with fundamentals and other indicators. (For additional reading, check out: How to Use Volume to Improve Your Trading.)