Technical analysis – the practice of devising knowledge from stock charts – is almost unlimited in its complexity and potential for further complexity. You might well wonder why people would make stock picking so complicated. Why not just rely on the basic indicators, like whether the stock price is up or down? Well, those who use technical analysis are basically trying to disprove that boilerplate language found in disclaimers everywhere: "Past performance is not indicative of future results."
One of the more sophisticated tools used in technical analysis is the percentage price oscillator, which measures momentum. To figure out what a percentage price oscillator is and why we'd care, we have to start with the concept of an exponential moving average (EMA), which is critical to many aspects of technical analysis.
Exponential Moving Average
The exponential moving average of a stock is nothing more than its average closing price over a certain number of days, with more recent days weighted more heavily – exponentially, in fact. That's contrasted with a simple moving average, in which every day of the period counts equally.
When does a random uptick or downtick in a stock's price become or portend a trend? In other words, how many days should you use to calculate an exponential moving average? The longer the period, the more methodical and gradual the exponential moving average's journey will be. The shorter the period, the more closely the graph of the exponential moving average will resemble the graph of the stock's unvarnished day-to-day price. An exponential moving average needs to be calculated over a period of appropriate length to maximize meaningful data while minimizing random movement.
Tradition and convention have deemed 26 days to be the dividing line between the short term and the "minor intermediate" term in the stock market, with the "very short" term lasting between five and 13 days. Perhaps that's arbitrary, but it does give us a starting point and some underlying logic for working with exponential moving averages of varying lengths.
Calculating the Percentage Price Oscillator
The percentage price oscillator is simply the nine-day exponential moving average, decreased and then divided by the 26-day exponential moving average.
Percentage Price Oscillator=EMA26−dayEMA9−day−EMA26−daywhere:EMA=exponential moving average of stock’sclosing price
This isn't intended as mere algebraic manipulation either – subtraction and division for their own sake. The idea is to look at the short-term average in comparison to the longer-term average, while staying impervious to the effects of sudden recent movements. Essentially, we're looking at the nine-day average as a fraction of the 26-day average; hence, percentage price oscillator.
Take a look at the following chart. It shows the percentage price oscillator for Berkshire Hathaway Inc. (BRK.A), using the parameters listed above. The black line is the percentage price oscillator. The red line represents the nine-day exponential moving average, while the blue histogram indicates the difference between the red and black lines.
In practice, the result of the calculation will be something like "+10%," which would mean that the underlying security's nine-day exponential moving average exceeds its 26-day counterpart by 10%. A positive number indicates an upward trend and a signal to buy.
By the way, nine- and 26-day exponential moving averages are not dictated by Scripture. Some analysts use 12 and 26 days, some use 10 and 30, and others use other combinations. Whatever lengths the analysts choose, they shouldn't differ much from 9 and 26 days, which are the generally accepted lengths that define very short term and minor intermediate term. A percentage price oscillator calculated with 10- and 26-day exponential moving averages will be close in value to one calculated with nine- and 30-day exponential moving averages. The oscillators certainly won't differ enough to turn a buy decision into a sell one.
The Elegant Indicator
One advantage to the percentage price oscillator is that it's a dimensionless quantity, a pure number that isn't fixed to a value such as the price of the underlying stock or other security. Also, because the percentage price oscillator compares two exponential moving averages, it lets the user compare movements through different time frames. The price of the security itself becomes almost of secondary importance. Unlike lots of other popular analytical tools, the percentage price oscillator measures relative price differences, not absolute ones.
The value of the percentage price oscillator is also an indicator of stock volatility, with a higher percentage indicating higher volatility. Volatility is a desirable condition in some instances and an undesirable one in others, but the theory goes that the percentage price oscillator is best used in conjunction with a buy or sell signal. A high (positive) percentage price oscillator ought to encourage investors to buy only when coupled with an already extant signal derived via some other means. Similarly, a low (negative) percentage price oscillator should impel little action on its own, but it can reinforce a sell decision when a sell signal is already present.
The Bottom Line
The percentage price oscillator's value is its ability to fuse trends of short and intermediate lengths into a single elegant ratio. On its own, it's of limited worth, but when combined with knowledge of the market, an appreciation of fundamentals and an understanding of the difference between investing and speculation, prudent use of the percentage price oscillator can pay tangible rewards to the bright investor.