As opposed to a trend indicator, an oscillator appears at the bottom of the main chart. Based on a mathematical formula, an oscillator shows extreme price levels. The majority of oscillators are created to highlight overbought and oversold levels. Depending on the type of oscillator, they highlight a type of extreme price activity. Oscillators can help investors identify these areas of extreme trading activity, and they can then choose to, either go short when an overbought level is reached, or long when an oversold level is reached. Since the personal computer made it possible to compute sophisticated formulas to plot technical indicators, a variety of oscillators exist. The standard “equipment” for a trading platform, like MT4, looks like this:
That’s quite a list, with some of the most exciting oscillators on it. And remember, if any oscillator doesn’t come with the default settings of your trading platform, it can easily be imported if it has the right format.
Oscillators mimic the price action of a currency pair. The more periods (candlesticks) it considers, the more relevant the information will be. However, the downside of using more periods is that the oscillator’s line flattens so much that it becomes difficult for it to reach overbought and oversold levels. For this reason, most investors use the default period or even smaller ones to identify early changes in prices.
Besides highlighting overbought and oversold levels, an oscillator also shows divergences. Bullish or bearish trends are identified when the oscillator doesn’t confirm the price action. As the oscillator considers more periods while the price always refers to the action in the last candlestick, investors often tend to stay with the oscillator, act based on what it shows, and wait for the currency pair to respond.
Relative Strength Index
By far the most popular oscillator, developed by Welles Wilder, is the RSI (Relative Strength Index). This oscillator only moves in positive territory and is considered overbought above 70 and oversold below 30.
One point to note with overbought and oversold level indicators for oscillators is that they are only effective when the market is within a specific range. When it is not in range, investors tend to use divergences to spot potential trend reversals.
The diagram above shows recent price action in the EUR/USD pair resulting in a bearish divergence. At the last ECB (European Central Bank) meeting and press conference, the pair made a new marginal high.
However, the RSI failed to confirm the second high and it formed what is known as a bearish divergence.
As the most representative oscillator of them all, the RSI illustrates what overbought or oversold levels are and how divergences form. Other oscillators show variations of the same thing, but on different levels and using different formulas. The oscillators most used by Forex investors are:
- MACD (Moving Average Convergence Divergence) – when it crosses the zero line investors use it as a trend indicator; it is excellent at showing divergences.
- DeMarker – it acts in a similar, almost identical fashion with the RSI.
- Stochastics – with overbought levels above 80 and oversold levels below 20, its signal line is followed by many investors.
- CCI (Commodity Channel Index) – an old oscillator, travels above and below +100 and -100. However, those levels weren’t designed for the Forex market so expect the market to move well beyond them.
- Oscillators appear on a small window at the bottom of a chart.
- They show overbought and oversold levels.
- Investors also use them to help identify bullish and bearish divergences.
- RSI is the most popular oscillator among Forex retail investors.