Oscillators
From FXPedia
When it comes to market psychology, momentum is a major factor that can prolong what would have otherwise been a short-lived price rally or bear run. Nevertheless, of one thing you can be certain – all trends eventually reverse and you do not want to be left behind when the market for a currency pair suddenly turns.
To help identify price reversals, there are several technical analysis tools that attempt to measure momentum and translate this information into a quantifiable measurement to help you determine whether a directional move is at the end of its run or if it still has enough steam to continue.
Unlike most tradable securities such as equity stocks, there is no way to determine volumes being traded on the currency markets. When trading stocks, you can view traded amounts in near real-time and if volumes are tapering, this is a strong signal that momentum for the stock in question is waning. However, because forex is an over-the-counter market with no central location to track the number of transactions, forex traders make use of momentum metrics using what are broadly referred to as momentum oscillators.
Oscillators work under the premise that as momentum begins to slow, fewer active buyers and sellers are willing to trade at the current price. In a rising bull market, slowing momentum could indicate that an upper resistance level has been reached and prices have peaked and may be about to reverse. In a falling bear market, the opposite scenario is suggested with a slowing momentum suggesting that the price is near a support level and traders may be looking to buy at a bargain which could reverse the bear trend.
In this brief introduction to Oscillators, we will look at two basic types – moving averages and trend directional identifiers. However, before we do, a quick look at the basic concepts of how momentum is measured by oscillators.
Evaluating Momentum Within a Range
When evaluating momentum, it is best to limit the evaluation to a manageable range otherwise it may be too difficult to spot a trend. When determining a range, look for the beginning of a sustained price movement – either up or down – and set this as the starting point.
The upper and lower ranges of a momentum study – that is, the upper and lower limits of the oscillator scale – are often referred to as overbought for the upper limit and oversold for the lower limit. This is because the upper limit marks the point where the market moves from a bull (or buying) market to a bull (or selling) market – the lower limit is the point where the market turns to a buying market from a selling market.
Moving Averages
Moving averages are calculated by placing a trend line representing the current average over a price chart. As the rate fluctuates with the latest rates (i.e. the “moving” part), you can easily determine whether the latest rates fall above or below the trend line as well as the overall deviation from the average.
The Moving Average Convergence / Divergence – MACD for short – is an example of using trend lines showing average prices for different time frames on one chart. For example, say you want to watch EUR/USD; you could create a MACD chart with two average price trend lines – one trend line shows the average rates for the past three hours, while the other tracks rates for the past ten minutes. If the short-term moving average moves up and surpasses the longer term average, this is a signal that the rate is trending upwards and the greater the deviation, then the more pronounced the uptrend.
On the other hand, if the short-term moving average falls below the longer-term average, then this is an indication that the rate is trending down. Again, the greater the deviation, the stronger the trend.
- Sample Moving Average Chart – courtesy OANDA Corporation
Trend Directional Identifiers
In addition to moving averages, there are a couple of other oscillator types that we should look at here, starting with the Relative Strength Index.
Relative Strength Index (RSI)
The Relative Strength Index (RSI) is one of the more widely-used rate direction identifiers. As the name implies, it measures the strength of the rate movement and is based on the concept that rates are generally “elastic” in nature. This means that rates can move only so far from the mean rate before the overall direction can be determined. This is what is meant by relative strength and the RSI provides insight into the trend’s ability to “break” away from the average mean rate.
Typically, a rapid rate increase results in an overbought situation while rapid price decreases bring about an oversold situation – in either case you can expect the price to work its way back to a more accurate level.
The RSI index forms chart patterns in the same manner as we have discussed at the beginning of this chapter – review the implications of tops and bottoms, head and shoulders, and other common chart patterns for more information.
Directional Movement Indicators (DMI)
The Directional Movement Indicator (DMI) is used to determine if an exchange rate is trending and – much like the RSI – attempts to show the strength of the current trend. The DMI is based on the assumption that when the trend is downwards, the current low should be lower than the previous period’s low – conversely when the trend is upwards, the current high should exceed the previous period’s high.
The DMU uses four lines to determine trends and trend direction:
| +DI | This is the positive directional indicator (DI) and shows the difference between the current high and the previous period’s high. A series of periods is used to provide the data to create the +DI line. |
| -DI | This is the negative directional indicator and shows the difference between the current low and the previous period’s low. Again, previous periods are used to create the –DI line. |
| ADX | This is the Average Directional Movement Index and produces a moving average of the difference between the +DI and –DI lines. The higher the ADX, the greater the current trend. Note however that the ADX does not distinguish between a rising and a falling market – it merely indicates the depth or degree of the trend. |
| ADXR | This is the Average Directional Movement Index Rating – it shows the average of the ADX values calculated by averaging a series of ADX over several prior periods. As is the case with the ADX, the greater the difference, the stronger the current trend. |
- Relative Strength Index Chart – courtesy OANDA Corporation
Stochastic Oscillator
The Stochastic Oscillator compares the period closing rates with the high and low for the current period to help you identify trends. The ability to show trends in this manner is based on the assumption that the market will close at the upper end of a reporting period’s range when the trend is moving upwards; for a downturn, the expectation is that the rate will close at the lower end of the range. Thus, any intra-period highs that form indicate an over-bought position as the market could not support the price. Conversely, intra-period lows represent an over-sold position as the market participants eyeing a buy opportunity, were willing to buy and force the price upwards.
There are two basic stochastic types – fast stochastics and slow stochastics . Fast stochastics are very sensitive to rate changes and are considered by some traders to be too volatile – for this reason, slow stochastics are seen by some analysts as the more reliable approach.
- Slow Stochastic Chart – courtesy OANDA Corporation
Related Links
- An Introduction to Technical Analysis
- Ask Price, Average Price, and Bid Price Line Charts
- Fibonacci Retracements
- Advance / Decline Line
- Oscillators
- Technical Analysis vs. Fundamental Analysis
