What Is the Derivative Oscillator?

The derivative oscillator is a technical indicator that applies a moving average convergence-divergence (MACD​) histogram to a double-smoothed relative strength index (RSI) to create a more advanced version of the RSI indicator.

Key Takeaways

  • The derivative oscillator is the difference between a double-smoothed RSI and an SMA of the double-smoothed RSI.
  • The derivative oscillator is frequently shown as a histogram.
  • Zero line crossovers are one way to generate trade signals with the indicator. Divergence may also be used.

Understanding the Derivative Oscillator

The derivative oscillator was developed by Constance Brown and published in the book Technical Analysis for the Trading Professional. This technical indicator is a more advanced version of the relative strength index (RSI) that applies moving average convergence-divergence (MACD) principles to a double-smoothed RSI (DS RSI) indicator.

The indicator is derived by computing the difference between a double-smoothed RSI and a simple moving average (SMA) of the DS RSI. The indicator's intent is to provide more accurate buy and sell signals than the standard RSI calculation. The derivative oscillator can be used at any time frame.

The MACD is derived by subtracting the 12-period exponential moving average (EMA) from the 26-period EMA. It is in this way that the derivative oscillator uses MACD principles, since the derivative oscillator is also derived from subtracting the SMA from the double-smoothed RSI.

The derivative oscillator is used in the same way as the MACD histogram. Positive readings are considered bullish, negative readings are considered bearish, and crossovers above and below the zero line signal indicate potential buying and selling opportunities. Traders may also look for divergence with the security's price, which could be an indication of an upcoming reversal in the prevailing trend. This happens when the indicator falls and the price rises or when the price falls and the indicator continues to rise.

Traders should consider using the derivative oscillator in conjunction with other forms of technical analysis, such as price action analysis and chart patterns.

Derivative Oscillator Example

The following weekly chart of Apple Inc. (AAPL) has a derivative oscillator applied to it. Zero line crossovers are marked with vertical lines and arrows. Buy and sell signals would occur at the close of the day when the signal occurs or at the following open.

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Image by Sabrina Jiang © Investopedia 2021

The indicator produces a number of trades, some only lasting a few weeks. The chart shows that this trading strategy can produce both profitable and losing trades so, once again, risk management is key. The strategy is most susceptible to a large number of losing trades when the price is moving sideways and the stock (or another asset) lacks direction.

A variation on the strategy is to buy when the indicator turns up and sell when the indicator turns down, instead of waiting for a zero-line crossover. In this example, the indicator is colored green when it is moving higher and red when it is moving lower. This provides earlier entry points into rallies and earlier exits during declines. While this method works well when the price is making large swings and trending, the method is prone to many false signals and losing trades, when the price action is choppy or non-trending.

Derivative Oscillator vs. Stochastic Oscillator

The stochastic oscillator compares the current price to the price range over a defined period. This indicates whether the stock or other asset is strong or weak relative to its recent price range. The indicator is bound between zero and 100.

Despite different calculations, the stochastic oscillator, RSI, and the derivative oscillator will typically move in the same direction, although not exactly at the same time or with the same magnitude.

Limitations of the Derivative Oscillator

The derivative oscillator can produce a large number of trade signals, especially during choppy trading conditions when the indicator is most susceptible to giving false or losing signals. Signals can also occur once the price has already made a substantial move in a given direction. This could mean poorly timed entries or exits. It is important to note that this indicator is acting on past price information. There is nothing inherently predictive about the indicator in its calculation.