What do oscillators do?

Oscillators are one of the most popular types of technical indicators and only moving averages are more commonly used. Traders call this type of indicator an oscillator because they oscillate between two set values in a range. The location of the oscillator within the range can give traders some clues to the current market situation and potential future moves in price. Technical analysts use a wide variety of oscillators although the majority show the same information.

Oscillators in Technical Analysis

Oscillators are almost always a leading indicator, or indicators, that give clues about future prices, such as a trend reversal or the beginning of a new trend. Chartists watch both the current value of the oscillator and its trend as part of their analysis. The current value of the oscillator lets them know how strong the trend is while the trend in the oscillator itself shows whether a trend is gaining or losing momentum. The other use of oscillators is to detect market imbalances. It does this through overbought and oversold levels in the oscillator. For example, when prices rise too quickly it can cause the oscillator to rise to extreme levels. Traders would see this as the asset being overbought and will look for signs of a correction in price. The same is true if price drops rapidly, and the oscillator indicates the asset is oversold. The third use for an oscillator is to detect divergences between the market price and the indicator. For example, price may make new highs, but the oscillator stops rising, or even declines, showing a potential bearish divergence. In such a scenario a trader would speculate that the falling oscillator shows a bullish trend running out of steam and a reversal soon to come. These types of divergences are more common when markets reverse from bull to bear.

Oscillator Pros and Cons

Traders know oscillators are most useful during periods in which markets are moving sideways. Since that is roughly 70% of the time, oscillators are an excellent tool for any trader to determine overbought and oversold levels within the market and act accordingly. One problem that trader’s encounter with oscillators is when new trends are beginning. At these times the oscillator will give an overbought or oversold signal, but these extreme levels can remain for a long time. That will often trap traders into trades that cause excessive losses as the emerging trend gains momentum rather than reversing. One way to avoid this is to ignore oscillator signals anytime an asset breaches a support or resistance level, as these are often where the beginning of a new trend is located.