Oscillators and Contrary Opinion

INTRODUCTION

In this chapter, we're going to talk about an alternative to trend­following approaches—the oscillator. The oscillator is extremely useful in nontrending markets where prices fluctuate in a hori­zontal price band, or trading range, creating a market situation where most trend-following systems simply don't work that well. The oscillator provides the technical trader with a tool that can enable him or her to profit from these periodic sideways and trendless market environments.

The value of the oscillator is not limited to horizontal trad­ing ranges, however. Used in conjunction with price charts during trending phases, the oscillator becomes an extremely valuable ally by alerting the trader to short term market extremes, commonly referred to as overbought or oversold conditions. The oscillator can also warn that a trend is losing momentum before that situation becomes evident in the price action itself. Oscillators can signal that a trend may be nearing completion by displaying certain divergences.

We'll begin by explaining first what an oscillator is and the basis for its construction and interpretation. We'll then discuss the meaning of momentum and its implications for market fore­casting. Some of the more common oscillator techniques will be presented from the very simple to the more complicated. The important question of divergence will be covered. We'll touch on the value of coordinating oscillator analysis with underlying mar­ket cycles. Finally, we'll discuss how oscillators should be used as part of the overall technical analysis of a market.

OSCILLATOR USAGE IN CONJUNCTION WITH TREND

The oscillator is only a secondary indicator in the sense that it must be subordinated to basic trend analysis. As we go through the various types of oscillators used by technicians, the impor­tance of trading in the direction of the overriding market trend will be constantly stressed. The reader should also be aware that there are times when oscillators are more useful than at others. For example, near the beginning of important moves, oscillator analysis isn't that helpful and can even be misleading. Toward the end of market moves, however, oscillators become extremely valuable. We’ll address these points as we go along. Finally, no study of market extremes would be complete without a discussion of Contrary Opinion. We'll talk about the role of the contrarian philosophy and how it can be incorporated into market analysis and trading.

Interpretation of Oscillators

While there are many different ways to construct momentum oscillators, the actual interpretation differs very little from one technique to another. Most oscillators look very much alike. They are plotted along the bottom of the price chart and resemble a flat horizontal band. The oscillator band is basically flat while prices may be trading up, down, or sideways. However, the peaks and troughs in the oscillator coincide with the peaks and troughs on the price chart. Some oscillators have a midpoint value that divides the horizontal range into two halves, an upper and a lower. Depending on the formula used, this midpoint line is usu­ally a zero line. Some oscillators also have upper and lower bound­aries ranging from 0 to 100.

General Rules for Interpretation

As a general rule, when the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may have gone too far too fast and is due for a correction or consolidation of some type. As another general rule, the trader should be buying when the oscillator line is in the lower end of the band and selling in the upper end. The crossing of the midpoint line is often used to generate buy and sell signals. We'll see how these general rules are applied as we deal with the various types of oscillators.

The Three Most Important Uses for the Oscillator

There are three situations when the oscillator is most useful. You'll see that these three situations are common to most types of oscillators that are used.

1. The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its bound­aries. The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. This warns that the price trend is overextended and vulnerable.
2. A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.
3. The crossing of the zero (or midpoint) line can give impor­tant trading signals in the direction of the price trend.

Figure 10.1a The 10 day momentum line fluctuates around a zero line. Readings too far above the zero line are overbought, while values too far below the line are oversold. Momentum should be used in conjunction with the trend of the market.

MEASURING MOMENTUM

The concept of momentum is the most basic application of oscilla­tor analysis. Momentum measures the velocity of price changes as opposed to the actual price levels themselves. Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10 day momentum line, simply sub­tract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line. The formula for momentum is:

M = V - Vx

where V is the latest closing price and Vx is the closing price x days ago.

Figure 10.1b A comparison of 10 and 40 day momentum lines. The longer version is more helpful in catching major market turns (see circles).

If the latest closing price is greater than that of 10 days ago (in other words, prices have moved higher), then a positive value would be plotted above the zero line. If the latest close is below the close 10 days earlier (prices have declined), then a negative value is plotted below the zero line.

While the 10 day momentum is a commonly used time period for reasons discussed later, any time period can be employed. (See Figure 10.1a.) A shorter time period (such as 5 days) produces a more sensitive line with more pronounced oscil­lations. A longer number of days (such as 40 days) results in a much smoother line in which the oscillator swings are less volatile. (See Figure 10.1b.)

Momentum Measures Rates of Ascent or Descent

Let's talk a bit more about just what this momentum indicator is measuring. By plotting price differences for a set period of time, the chartist is studying rates of ascent or descent. If prices are ris­ing and the momentum line is above the zero line and rising, this means the uptrend is accelerating. If the up-slanting momentum line begins to flatten out, this means that the new gains being achieved by the latest closes are the same as the gains 10 days ear­lier. While prices may still be advancing, the rate of ascent (or the velocity) has leveled off. When the momentum line begins to drop toward the zero line, the uptrend in prices is still in force, but at a decelerating rate. The uptrend is losing momentum.

When the momentum line moves below the zero line, the latest 10 day close is now under the close of 10 days ago and a near term downtrend is in effect. (And, incidentally, the 10 day moving average also has begun to decline.) As momentum con­tinues to drop farther below the zero line, the downtrend gains momentum. Only when the line begins to advance again does the analyst know that the downtrend is decelerating.

It's important to remember that momentum measures the differences between prices at two time intervals. In order for the line to advance, the price gains for the last day's close must be greater than the gains of 10 days ago. If prices advance by only the same amount as 10 days ago, the momentum line will be flat. If the last price gain is less than that of 10 days ago, the momen­tum line begins to decline even though prices are still rising. This is how the momentum line measures the acceleration or deceler­ation in the current advance or decline in the price trend.