As the financial markets move through time, they move up, down and sideways as demand for a product increases and then decreases. Prices will constantly oscillate which means they will move around as the markets trends through secular long term trends.
A key tool for technical traders is to be able to model and gauge two extreme values within a particular band of prices. Oscillators are technical analysis tool that are banded between two extreme values and built with the results from a trend indicator for discovering short-term overbought or oversold conditions. As the value of the oscillator approaches the upper extreme value the asset is deemed to be overbought, and as it approaches the lower extreme it is deemed to be oversold. Most oscillators are built on determining the momentum of the market. As the relative value of prices continues to climb over a short period of time, the oscillators create a warning signal that is considered overbought and the same is true for values that are considered oversold.
The term overbought is a situation in which the demand for a certain asset unjustifiably pushes the price of an underlying asset to levels that do not support the fundamentals. In technical analysis, this term describes a situation in which the price of a security has risen to such a degree, usually on high volume , that an oscillator has reached its upper bound. This is generally interpreted as a sign that the price of the asset is becoming overvalued and may experience a pullback.
The term oversold is a condition in which the price of an underlying asset has fallen sharply, and to a level below which its true value resides. This condition is usually a result of market overreaction or panic selling. In technical analysis where the price of an asset has fallen to such a degree, usually on high volume, that an oscillator has reached a lower bound. This is generally interpreted as a sign that the price of the asset is becoming undervalued and may represent a buying opportunity.
Relative Strength Indicator.
The Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. It is calculated using the following formula:
RSI = 100 - 100 / 1 + RS
RS = Average of x days’ up closes / Average of x days’ down closes
When the Relative Strength Index reached a level of 20, which occurred in December of 2009, the USD/JPY currency pair would be considered oversold and would have reached a point where the oscillator would create a buy signal. A trader using RSI should be aware that large surges and drops in the price of an asset will affect the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to other technical tools. RSI can also be used as an indicator that signals a slowing of momentum. When a financial instrument makes a new high, but the RSI does not make a corresponding new high, the indicator is telling the investor that the momentum is slowing. For example, in the chart below of the EUR/USD, the RSI made a corresponding high in the October/November 2009 time frame, but when the EUR/USD made a new high above 1.50 in December of 2009, the RSI was not able to make the same new high. This presented a divergence opportunity and was a signal for technical traders to sell the EUR/USD.
Stochastic
A Stochastic oscillator is a technical momentum indicator that compares a security’s closing price to its price range over a given time period. The oscillator’s sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result. This indicator is calculated with the following formula:
%K = 100[(C - L14)/(H14 - L14)]
C = the most recent closing price
L14 = the low of the 14 previous trading sessions – H14 = the highest price traded during the same 14-day period.
Stochastics are used in a way that is similar to the RSI. Traders will usually use a range of 70 to designate an overbought area, while they will consider 30 to be an oversold area of the trading range. Additionally, traders will also consider a stochastic crossover to be significant. When a fast stochastic readying crosses above or below a slow stochastic readying, the market could be turning. In December of 2009, the slow stochastic crossed below the fast stochastic which signified a period of coming lower levels for the EUR/USD.
See also:
