OscillatorsUnlike moving averages, which show the direction of the trend, oscillators provide information about the momentum of the trend currently in place. They usually appear on their own chart, but are lined up with the price chart along the x-axis to show price momentum at their respective times.
By presenting momentum in many different ways, oscillator indicators can provide buy and sell signals by showing where the asset might be overbought or oversold, and thus indicate where a trend change might occur.
Some common oscillators are the Moving Average Convergence/Divergence (MACD), Stochastic, Relative Strength Index (RSI), Rate of Change (ROC), and Commodity Channel Index (CCI). A couple of these will be discussed in more detail below.
Relative Strength Index (RSI)The Relative Strength Index, or RSI, is quoted a lot in analysis that you might read about Forex or stocks.
The frustration with the RSI (and its many commentators out there) is that they have oversimplified the power of this indicator. So this lesson will attempt to set the record straight, showing you exactly why it’s so powerful, how you can use, and how to avoid the potential pitfalls you can run into if you’re not careful.
The RSI is a momentum indicator. Momentum indicators are designed to try and highlight when trends are coming to an end or there is a possibility for a turn in the market.
In its most simplistic form, the RSI highlights areas where something is overbought or oversold. The RSI has a range of 0 to 100. A reading of above 70 is considered overbought. A reading of below 30 is considered oversold. And knowing that information in addition to what you can see on your normal price chart can help you decide whether a trend on a Forex pair is likely to continue, or end and reverse.
It sounds pretty simple, and very useful for trading. But there’s one important myth that needs to be dispelled:
- A reading above 70 does NOT mean go short.
- A reading below 30 does NOT mean go long.
Maybe you’ve been told otherwise in the past. But don’t fall into this trap.
For an example, take a look at this chart of the EURUSD.
Highlighted on the charts are corresponding areas of oversold on the RSI, and the candles the oversold reading relates to. There is also an area of overbought, and the candles the overbought reading relates to.
As you can see from this chart, actually taking a long in oversold and a sell in overbought looks to be doing okay. The first trade long on the far right has played out quite well. At the second box on the RSI, the overbought region, they have exited the long and gone short. So far, so good.
At the third box, they exit the short, meaning they now have two profitable trades and are on a roll. So, to the third trade. Long from the third box, technically below 30 on RSI, so that is an oversold region.
Some traders might have taken that move below 30 on the RSI as a signal to back up the truck and buy EURUSD, especially if they had listened to certain people. Okay, it was certainly flashing up ‘oversold’ – but take a look at what happens next:
See how the price continues to drop? Now your long trade - had you taken it when the RSI flashed ‘oversold’ - would be significantly out of the money.
That proves that you need to be smarter with the RSI. So, how do you trade this indicator?
Well, it is extremely powerful once you add in a few other rules and start to consider what the indicator is actually telling us.
The three main ways of using the RSI are:
• Supporting a trade. When in a strong uptrend (you can use moving averages to define this), you can use the RSI to highlight when to enter into a long position. In other words, do not buy in overbought, wait for the bounce and turn then enter long. Conversely, the opposite is true for a downtrend. This works especially well when trading trends on a higher timeframe and using RSI on a lower timeframe. For example, trading the trend on 4-hourly charts and looking for oversold and overbought regions on the hourly charts. The absolute key to remember here is that this only works with a strong trend.
• Highlighting trends in the market. Higher highs in momentum means the market is starting to trend more aggressively to the upside. Lower lows means you are trending down more aggressively.
• Finally, using both points above, looking for Divergence. It cannot be overstated how powerful divergence between price and a momentum indicator is.
If there is a strongly trending bullish market (going up), expect to see the momentum indicator trending in the same direction.
As soon as you see a downward trending momentum indicator and an upward trending price, that’s a warning signal. It is a sign that the market may well be losing momentum and is about to turn.
Trading this simple fact alone is a highly profitable strategy.
Below is the daily chart for AUSD:
The initial starting point is based on a peak in the RSI (circled).
The RSI has been trending down with price. See how, towards the end of April, price started to flatten and bottom with the RSI.
RSI then reversed and the price moved lower in a nice smooth downtrend.
There is then an area of oversold on the RSI. This is a clue, but at this moment you know this is a dangerous signal, so hold off going long, given that there is such a strong trend.
Four days past the initial signal, the price drops lower (as seen by the two large red candles), and the RSI has moved up, so you’ll be pleased you didn’t enter long so soon.
Here, there is a sign of Divergence and a potential loss of momentum. But you still shouldn’t go long yet, because it’s best to look for multiple signals pointing to the same thing.
Take a look at the next chart:
This shows the same AUDUSD chart, but on a few more days. As you can see, the RSI continues to move higher as Price moves lower.
Then there is a nice long entry signal.
Those really long tailed candlesticks are a tell-tell sign, and offer a good trading opportunity. These offer a nice entry point for a long trade.
You can then see how this played out.
Yes, that’s right, you could have made from 0.9700 to 1.0400 using this one initial technique. That’s 700 pips in one trade – a very nice long trade. And what’s more, if you also used the Moving Average technique mentioned earlier, you could have netted yourself a lot of money by increasing your trade size on the dips back to the dynamic support.
StochasticsStochastic oscillator, often simply referred to as ‘Stochastics’, is a momentum indicator.
Essentially, it compares the closing price of an underlying with the underlying’s range as defined by support and resistance levels.
In the majority of versions of the indicator you will see two separate lines plotted: the D line and the K Line (sometimes, and more correctly, referred to as the %K and %D line).
The K line provides the momentum based on closing price and high and low, where we define the number of periods for the high and low. The D line is most commonly the 3 period EMA of the K line.
These results are normalised on an index value between 1 to 100. Here they are on the recent EURUSD action.
Here, the stochastic indicator has been set up with %K the yellow line, with a 21 day range and the %D line, green line, as a 3 period EMA of a 14 Period K line.
Simple rules on the above are to look for a cross between the %K and %D line.
Essentially, on the chart above, yellow above green is bullish, and yellow below green is bearish.
Similar to the RSI, this indicator also has an overbought and oversold region. Typically, a value below 20 is an oversold region, and a value above 80 is overbought.
When you combine the oversold and overbought regions with the crossing of the lines, these signals become more powerful.
In the example below, square boxes have been drawn to indicate where the %K line (yellow line) crosses above the %D line (green line) in an oversold region. Where the %K line crosses below the %D line in an overbought region, this has been indicated as a circle.
In short, the square is a potential long entry, and the circles are potential short entry signals.
Hopefully you are starting to see why this indicator works so well.
Below, the chart has been scrolled back further so you can see what happened previously with these signals. The same rules as before apply regarding the circles and squares.
This becomes interesting if you start to use your support and resistance lines to move stops on these trades to recent highs and lows to capture the trend.
Remember the support and resistance strategy of joining highs and lows together? Well, if you wanted to take the above and build it into a strategy, a good tip would be to look at how you could use stops based on support and resistance and trail these stops to capture large trends.
Another hint would be that this works on lower timeframes, and to try combinations of the following sequence of numbers for the %K and %D lines; 3, 5, 8, 9, 13, 14, 21, 34.
In a similar way to the RSI, this indicator also has some hidden extra features.
Divergence on the RSI is a powerful tool to help traders, and it turns out you can apply the same divergence technique to the stochastic oscillator as well.
You can apply divergence on the %K line to offer warning signals in the same way this is done on the RSI indicator.
You can also use the %D line (the green line on the charts) to offer a divergence signal between the underlying and the line itself.
On the chart below, a slightly different stochastic oscillator has been plotted on the GBPUSD to highlight a divergence area between the D line (green line) and the actual price.
You can see here that there is no real follow through for what should be a push higher.
You can use this as a warning sign, and when you then see the cross in the stochastics lines, it gives you a good entry point.
It’s most definitely a good indicator to have in your arsenal of tools to help improve the probability of your trades.
BollingersInvented by John Bollinger, Bollinger bands are a moving average (normally a simple moving average) and X standard deviations from that average.
Common settings for Bollinger bands are a 20 period moving average (this is an example of a simple moving average) and 2 standard deviations.
What this will draw on your chart is a moving average with an upper and lower band, where the upper band is +2 standard deviations and the lower band will be – 2 standard deviations.
Standard deviation gives an idea of how much variation there is from the average.
In a completely random set of results, slightly over 95% of all results should be within 2 standard deviations from the mean, and over 99% should be within 3 standard deviations from the mean.
Translating this to price movements, assuming that price is completely random, in theory there is a large chance (around 95%) that the next price the market makes will be within the upper and lower Bollinger bands (assuming you use our default setting above).
Whether price is completely random or not is an argument for another day – but for the moment, assume it isn’t. Even then, the upper and lower Bollinger bands provide a good boundary for how far price may move in a certain period.
Taking this to the next level, you can look at two certain environments: trending and non-trending markets. In a trending market, price will be pushing in one direction. With regards to Bollinger bands, this means that price will be pushing on the upper or lower boundary as it moves in that direction.
In non-trending markets (range bound / choppy) the Bollinger bands can act as barriers to price.
Instantly, you should be thinking about how this could be used to create a strategy.
Let’s say you are in a range bound market, or a low volatility environment. In order to find out whether you are in this environment, you can use a few different indicators. Use ADX (which gives an idea of volatility), moving averages or MACD (see below) to give you some clues. Then, once you have identified this range bound environment, you can use the Bollinger bands as a guide to potential price movements.
One common strategy people use is called fading. What you need to look for in these situations is an extreme price movement in low volatility, which you will then take the opposition position of.
An example using Bollingers would be to plot the 20,2 and 20,3 Bollinger bands on a chart.
You then need to look for price to hit or touch the outer Bollinger and then start to move back into the Bollinger range. If price then breaks or closes above the inner Bollinger, you can get in the direction towards the moving average.
Assuming you are trading the UK session, then this is your potential play.
Running relatively tight stops on lower timeframes will allow you to use this to capture a fade in the opposite direction.
The key with this strategy is to ensure you are in a low volatility environment and that you stick to your trading sessions.
In a higher volatility environment or trending / breakout environment, you can use the touch or break of the 2 and 3 Bollinger bands to highlight where the trend is going, as shown before.
In trending environments, you can use a pull back towards the moving average (mid line) to enter into the direction of the trend.
Again, this allows you to run tight stops in order to attempt to capture the trend.
These systems tend to work well on lower timeframes, and when used with good risk / reward money management offer some really good strategies on highly traded pairs (like the EURUSD).