If trend indicators appear on the actual chart, right on the candles, oscillators are different. They are plotted in a separate window, right at the bottom of a chart. The thing that is missing when trading with trend indicators is the fact that, because they lag, price reversals are difficult to spot. It is not the same when trading with oscillators.
An oscillator is the result of a mathematical formula that applies to previous prices. Usually, this formula is based on the closing prices of the candles considered. Nevertheless, the oscillator places a value at current prices. It means that if the actual price of the day plots a value when a candle closes, the oscillator is doing the same.
Most of the times, the oscillator is mimicking the price movements. Traders use oscillators to find differences between the two. Because the oscillator considers more candles before plotting a value, it is viewed as more reliable. Therefore, if one is to choose between price and oscillator to find out which one is making a fake move, chances are the price is showing that move.
The oscillator is always to one to rely upon. The most famous oscillators used by retail traders are:
- Relative Strength Index (RSI). The RSI is one of a kind. There is no trader in this world that doesn’t know about it. The default setting or period for the RSI indicator is 14. It means that it considers the previous 14 candles before plotting a value on the screen. For this reason, it is more reliable than the actual price. The RSI travels only in positive territory and shows overbought and oversold levels. An overbought level is considered when the price travels above the 70 level, while an oversold level is when the RSI dips below the 30 level. Traders sell in the first case and buy the second one. While this is true in ranging markets, in trending markets this approach is not that good in terms of the profitability of the signals being generated. The best way to trade with the RSI is to use overbought and oversold levels in ranging markets (like in the Asian session, that is dominated by ranges) and look for bullish or bearish divergences in trending markets, as they will help to spot early reversals.
- Commodity Channel Index (CCI). The CCI is an oscillator that is more volatile than the RSI. When compared with the RSI, the CCI travels in negative territory too. The CCI’s default settings show the 100 and -100 levels, but this doesn’t mean the oscillator is traveling only between these levels. In strong market swings, the CCI can go even to 300 or -300 or more. While it is an oscillator, it is difficult to trade divergences with it. Most of the traders are using a move above 100 as an opportunity to go short and a move below -100 as an opportunity to go long. Beware though that this is something that doesn’t hold true all the time.
- Moving Average Convergence Divergence (MACD). The MACD has two main components: a histogram and a signal line. When the histogram rises, the market is bullish and when it falls, the market is bearish. The MACD travels in the negative and positive territory, and it can be traded in two ways. One is to look for divergences between price and the MACD’s histogram. A bullish one calls for a long trade, and a bearish one calls for a short trade. Another way is to simply look at the moment the oscillator crosses the zero level for a follow-up trade.
All these oscillators have one thing in common: they are more reliable than price because they are based on multiple candlestick prices. Even when trading CFD or other financial products, the principle is the same: look for divergences between the actual price and an oscillator.