Oscillators are indicators that are used when viewing charts that are non-trending to determine overbought or oversold conditions. Moving averages (MA) and trends are extremely important 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 is either 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 more, see: The Basics of Money Flow.)
The Relative Strength Index
The relative strength index is an indicator that measures the extent of recent price changes to determine overbought or oversold conditions in the price of a stock.
In the example below, you can see Microsoft Corp.'s 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.
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.
The 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 and 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.