Oscillators and Indicators

Indicators and Oscillators

Trend indicators and oscillators remain the popular choice for traders, despite the copious categories on offer through any trading platform. Hopefully this article will help to simplify the topic and pave the way for a deeper understanding of these essential analysis tools.

The primary point to remember is this:

Indicators are applied directly onto a chart, signalling a bullish trend in a dip or a bearish one in a spike. Oscillators on the other hand, must be employed through a separate window at the bottom of the screen. Some show trending conditions, but generally speaking oscillators interpret overbought and oversold levels.

A Brief Introduction

The preferred momentum oscillator is the RSI (Relative Strength Index). This is because, with high and low levels marked at 30 and 70 respectively, the RSI considers an oversold move to be when the price drops below 30 (suggesting to buy put options or go long) and overbought when surpassing 70 (trading to go short or buy put options). Fairly straightforward.

Alternative momentum oscillators, such as Stochastics, MACD, Accelerator, etc. can display the same overbought / oversold levels, using different indicator values. Example shown below.

Unfortunately a trader cannot be wholly reliant on simply identifying stocks that are overbought / oversold for viable trade entries, as this is valid only when the markets are ranging. When a market trends – keeping the stock in overbought / oversold levels – the biggest challenge for a trader is to remain solvent during this period.

To overcome this, I suggest looking for any momentum divergence between the price and the oscillator. With the indicator and asset heading away from one another, the price may be reversing and the implications can be either of the following:

  • A positive divergence / bullish – the price makes two consecutive lows with the oscillator not confirming the second move and moving upwards. Traders should look to buy call options or go long.
  • A negative divergence / bearish – the price makes two consecutive highs with the oscillator not confirming the second move and moving downwards. Traders should look to buy put options or go short.

Keep in mind that divergences are tricky, and signals from divergence that are based on oscillators can be difficult to read. Furthermore, the market may once again stay in a divergent mood more than a trader can remain solvent.

On the upside, using both analytical tools will provide you with an educated guess about potential turning points – whilst the price might refer to only one candle, the indicator will take into consideration bigger time frames when plotting values.

Popular Oscillators and Indicators

The Volume Indicator

We begin here with Volumes. Although I must stress, although this is a popular choice, and available on any trading platform, it is a tricky indicator to master.

Volumes is in actual fact just one of the volume indicators found on a trading platform, located as shown below on MetaTrader:

Before continuing it must be stated that this is a relative indicator, in the sense that it isn’t showing the volume of the entire fx market, only the volume experienced by the specific broker to which the trading platform belongs. So, you should always keep in mind that these volumes aren’t wholly representative.

Next, consider that only about 5% of speculators/investors within the forex market are retail traders (the same percentage demographic that the brokers are targeting). Now you should be able to understand why trading based on volumes, with a classical MetaTrader account designed for retail trading, is tricky.

Moving on, with access to the whole volume relating to the fx market, the oscillator should be opened in a separate window, below the chart. If you’re using a candlestick chart; a line representing the volume involved is plotted on the oscillator window as well as to each candle from the main window.

According to default settings, if the line is green, it will represent a bullish setup with more traders buying then selling – so going long, or buying a call option would be the way to go. The opposite of this is true as well, with a red line showing bearish conditions, and the higher the line, the more favourable it is to buy a put option or to short that market.

However, as always, there is a catch. There may come a point where the volume is green and the actual candle on the chart is red, or the other way around. Have patience. The ideal scenario is to sell when the candle and volume are displayed as red, and the volume is shown to be bigger than any previous red volume lines. Likewise it is a stronger bet to buy when the actual candle is green, and the volume is bigger than the previous green volume lines.

The MACD

MACD stands for Moving Average Convergence Divergence. As a well-known oscillator, MACD should be found listed under this category on your trading platform of choice. Upon selection, a separate pop up window will appear, offering adjustable parameter settings to form the oscillator.

As you can see in the above image, there are three moving average options with varying periods applied to them. The fast EMA (Exponential Moving Average) comes with the default setting of 12 – this simply means that it will be plotted based on the closing values of the previous 12 candles. In the same manner, the slow EMA comes with a setting of 26 and the MACD SMA (Simple Moving Average) a period of 9.

By clicking OK with these default settings, the oscillator will be plotted on the chart like this:

Trade decisions using such moving averages are dependent on the EMAs’ interactions with one another. When the fast EMA crosses above the slow EMA this can be interpreted as bullish and a trader should look to trade call options or go long. Should the fast EMA cross below the slow EMA, it is advised to trade put options or go short.

The sub-section of the above chart is the MACD overview. The wave of white candles reflects the movement of the EMAs by subtracting the slow EMA’s 26 days from the fast EMA’s 12.

The SMA line is shown on the MACD candles above in red. Traders can follow the behaviour of this line as it moves above and below the zero level. When the line rises above this is a signal that the shorter moving average is pulling away from the longer one, signalling upward momentum – here a long or call options should be traded. Similarly, when SMA dips below the zero line, put options should be traded and shorts taken.

Finally, divergences between price and MACD are useful in finding overbought and oversold areas. Such an example is shown in the image below:

The ADX Indicator

ADX stands for Average Directional Movement Index and is considered the ultimate trend indicator. Interestingly, whilst it is an indicator that shows the start or end of a trend, it’s actually plotted below a chart, and as such is categorised as an oscillator.

On Metatrader, you can locate the ADX as shown below.

After selection, the ADX’s default parameter settings are displayed to you in a pop-out window. Under the parameters tab you will see that a 14 period line is selected – this will be the timescale of your line and will sit below the chart. However, the ADX oscillator is constructed of three different lines, the other two, +DI and –DI, can be found under the colours tab. Take note of the attributing colours before continuing.

By clicking OK, the oscillator will finally be plotted, and in this instance, will appear like this:

The idea behind the ADX indicator is to spot trend reversals based on the +DI (the green line) and –DI (the pale line) crossing one another. Meanwhile, the blue line confirms if the cross represents the beginning of a new move – its focus is strength, whether these trends be up or down.

A bullish uptrend starts when +DI line crosses above –DI, with the blue line maintaining lower values than the + and – lines. When this is happening, we can go long or buy call options, keeping bullish until the blue line reaches overbought levels.

In order to locate these levels, historical data knowledge can be applied to see where the blue line has frequented. Once this is understood, the ADX indicator line can be edited and a new line should appear on the oscillator’s screen.

Once your blue line begins to reach these levels, trade should be closed or a put option traded, as either range or new trend in the opposite direction is about to begin.

Curiously for the ADX oscillator, on a bearish setup the –DI should indeed cross below the +DI, but the blue line must maintain the same conditions, sitting below the +DI and –DI, travelling in on the so-called overbought line.

Simply; the overbought line merely represents an estimate for when the trend is supposed to fade, whether it be bullish or bearish.

Bollinger Bands

One of the most important trend indicators is the Bollinger Band. The name originates from the famous technical analyst, John Bollinger, and is essentially represented by three moving averages: the UBB (Upper Bollinger Band), MBB (Middle Bollinger Band) and LBB (Lower Bollinger Band).

As the Bollinger is a trend indicator, it must be applied directly to an actual chart and not on a separate window (as is the classic difference between trend indicators and oscillators). To do so, this indicator can be found on Metatrader under the Insert tab by selecting clicking Indicators and then Trend – a popup window should appear to allow for further specifications, as seen in the images below.

As with any trend indicator, a trader uses it to locate support and resistance areas. With the aim to buy call options or go long on any dips (buying the dip if the trend is bullish), or to buy put options or go short on any spikes (selling into spikes if the trend is bullish).

The UBB and LBB may also act as support and resistance. Though I would advise caution when buying or selling a contrarian trade, as strong market trends would simply push against these two averages.

The MBB on the other hand, can be used to your advantage. It can be set up to be an SMA (Simple Moving Average) or EMA (Exponential Moving Average), though I recommend using the EMA. Whilst the SMA is static, the EMA is both dynamic and can adapt values as the UBB and LBB move, acting quickly to price changes.

In a bullish trend, the dips into the MBB are considered to be where the striking prices for binary options appear, or where a trade on the FX markets can be taken. At this level a trader should look for reversal patterns: morning or evening stars, hammers or hanging man formations, bullish or bearish engulfing patterns, dark-cloud cover or piercings, and even triangles. These reversal patterns often form on the lower time frames and as such, looking at triangles on the hourly chart is the best option if the MBB is being put to the test.

As with any indicator or oscillator, the Bollinger Band projects its values based on a specific period of time in the past. For example, setting the values of the EMA (essentially the MBB) to 20, the indicator will take into consideration twenty candles before plotting the values. The bigger the period, the more smooth the average will be – though the standard twenty shows the most accurate values and should always be used.

The Fibonacci Retracement

The Fibonacci is perhaps the most crucial trading tool. The Fibonacci Retracement, Extension, Time Zones and Arcs all play significant roles in helping traders find their path to success.

The Retracement tool can be applied to each and every time frame; the bigger the time frame, the stronger the support, or resistance level. In the example shown below, when trading a currency pair on a monthly chart, the Fibonacci tool can be dragged from the highest price to the lowest – the 50%, 61.8% and 38.2% retracement levels are considered to be important. These are far more significant than the same on the hourly chart or even on the lower time frames.

Aside from the support / resistance levels, the Fibonacci retracement or extension tool offers brilliant results when partnered with the Elliott Waves Theory, as everything is dependent on retracement or extension levels. For example, according to Elliott, the difference between a zigzag and a flat pattern originates from the fact that Wave B does not retract more than 61.8% in a zigzag, but goes above 61.8% in the case of a flat. Knowing this level is crucial in moving forward with your analysis.

As B Waves are always corrective, this same theory, along with Fibonacci extensions, apply to market corrections. For instance, in an impulsive move at least one wave will need to be extended, and this extension is usually applied to the third wave. In order to find out the target for the third wave, one has to take a Fibonacci extension tool and drag it from the beginning of the move to the end of the first wave and then to the end of the second wave. In the case of FX trading, the outcome represents a target for the third wave. In the case of binary trading, at the point of the price reaching the third wave extension, options in the opposite direction are recommended, as a correction should follow.

Fibonacci Time Zones are a tool few know how to use, but taking the time element into account it is imperative for successful trading. One method is to time a corrective wave in an impulsive move and then compare it with the next corrective move. According to the principle of alternation, these are supposed to be different and are usually related to 61.8% of the time.

It will become clearer as you embark on the practice of technical analysis, that Fibonacci tools are a necessity for every scenario. Without the application of these levels, the markets appear to be made up of random movements.

More About Support & Resistance Levels

To reiterate, it is a commonly known fact that markets spend most of the time in consolidation. Perhaps this is why many struggle with the aspect of locating support and resistance levels. With the financial market so often irresolute, it is important for a trader to know when the upper side of a range is moving in order to sell, or the lower is moving in order to buy.

By analysing a chart in various ways, a trader can be provided with the means for riding a trend through bigger time frames. This is where choosing the right indicator for the task at hand comes into play.

Let’s assume there is a bullish trend on the daily chart. This means that within the consolidation areas we would only be interested in buying the pullbacks – in other words, we’re looking for levels of support in order to add to our position, or to initiate a new position.

One way of finding this support level is to use oscillators, which come with overbought and oversold levels. In this particular example, we would be looking for an oversold area to reach the time frames that sit lower than that of the big trend. In such a case, we may use the RSI to find a bullish divergence on the hourly chart as a means to identify a support level and go long, or buy.

Another way to spot a support level would be to apply a trend indicator directly onto the daily chart. All trading platforms have a Trend Indicators list, where you will find the popular, previously discussed Bollinger Bands, as well as Moving Averages, Envelopes, Parabolic SAR, etc, available for use.

Alternatively, different technical analysis trading theories may be used to aid a trader. For instance, the Elliott Waves analysis can act as a tool to spot important resistance and support levels, along with Fibonacci retracement levels, in order to locate points to buy on a lower retracement or sell in a higher spike. Such examples may be used for the pinpointing of a bearish trend too (although, do keep in mind that the trades will be on the short direction, not on the long side).