An oscillator is a technical analysis tool that is banded between two extreme values and built with the results from a trend indicator for discovering short-term overbought or oversold conditions. As the value of the oscillator approaches the upper extreme value, the asset is deemed to be overbought, and as it approaches the lower extreme, it is deemed to be oversold.
Oscillators are most advantageous when a clear trend cannot be easily seen in a company's stock such as when it trades horizontally or sideways, and the most common oscillators are the stochastic oscillator, RSI, ROC and MFI.
Oscillators are typically used in conjunction with other technical analysis indicators to make trading decisions.
The purpose of an oscillators is to measure on a percentage scale from 0 to 100, where the closing price is relative to the total price range for a specified number of bars in a given bar chart. This is achieved through various techniques of manipulating and smoothing out multiple moving averages. When the market is trading in a range, the oscillator will follow the price fluctuations and indicate an overbought condition when it exceed 70 to 80 percent of the specified total price range, signifying a sell opportunity. An oversold condition exists when the oscillator falls below 30 to 20 percent, signifying a 'buy' opportunity.
So long as the price of the underlying security remains in the established range, the signals are valid. However, when a price breakout occurs, the signals may be misleading. A price breakout is either the resetting of the range for which the current sideways market is bound by, or the beginning of a new trend. During the price breakout, the oscillator will remain in the overbought or oversold range for an extended period of time depending on the extent of the breakout. Herein lies the dilemma that a trader is faced with. Should the trader buy the bullish breakout in the face of an overbought oscillator reading or, conversely, sell the bearish breakout into an oversold market.
The fact that oscillators are better suited for sideways markets make them more effective when used in conjunction with a technical indicator that identifies the market as being in a trend or range bound. For example, a moving average crossover indicator can be used to determine if a market is, or is not, in a trend. Once a confident determination is made that the market is not in a trend, the signals of an oscillator become much more useful and effective.