Oscillator Analysis

Oscillator analysis focuses on three main aspects to assess market momentum:

• Direction: Is the momentum bullish or bearish?
• Area: Is the market overbought or oversold?
• Divergences: Are there bullish or bearish conflicts between price and momentum?

1. Direction (Momentum Trends)

Momentum moves in trends, similar to prices. The same techniques used for analyzing price trends can be applied to oscillators.

• Using Trend Lines:
  • When the indicator goes below its trend line, it is a bearish signal.
  • When the indicator goes above its trend line, it is a bullish signal.
• Using Moving Averages:
  • When the indicator goes below its moving average, it is a bearish signal.
  • When the indicator goes above its moving average, it is a bullish signal.

Important Note: A trend reversal in momentum is not always associated with a similar reversal in price. Price remains the dominant factor.

2. Area (Overbought/Oversold Conditions)

Financial markets are driven by psychological forces (greed, fear), causing momentum indicators to fluctuate between extreme levels. Momentum reflects crowd psychology.

Banded Oscillators (0% to 100%)

• RSI and IMI: Extreme levels are typically beyond 70% (overbought) and 30% (oversold).
• Stochastic: Extreme levels are typically beyond 80% (overbought) and 20% (oversold).

Unbanded Oscillators (e.g., ROC, MACD)

These indicators have no fixed minimum or maximum values. Traders must manually identify overbought and oversold lines where the indicator shows a cluster of previous tops or bottoms.

Signals from Banded Oscillators (RSI/IMI)

Extreme momentum readings indicate a possible price correction:

• Bullish Signal: Indicator goes below 30 and then crosses above 30 from below.
• Bearish Signal: Indicator goes above 70 and then crosses below 70 from above.

3. Divergences (Price vs. Momentum)

Divergence occurs when the price and the oscillator are moving in conflicting directions. This serves as a warning that the trend may be about to change or a correction is imminent. Momentum oscillators serve as a leading indicator.

A. Classic Divergence

Classic divergence occurs at the end of a trend, signaling a reversal.

• Bullish Divergence (Positive):
  • Price makes lower lows.
  • Oscillator does not make lower lows (it moves flat or higher).
  • This suggests the decline is slowing and may signal a price rise.
  • Normally occurs at the end of a downtrend.
• Bearish Divergence (Negative):
  • Price makes a higher high.
  • Oscillator does not make a higher high (it moves flat or lower).
  • This suggests the rise is slowing and may signal a price drop.
  • Normally occurs at the end of an uptrend.

B. Hidden Divergence

Hidden divergence suggests the existing trend will continue (trend reversal in the correction).

• Hidden Bullish Divergence:
  • Price fails to move lower (makes a higher low).
  • Oscillator drops, making a lower low.
  • Signals a bullish trend continuation (occurs in an uptrend consolidation).
• Hidden Bearish Divergence:
  • Price fails to move higher (makes a lower high).
  • Oscillator rises, making a higher high.
  • Signals a bearish trend continuation (occurs in a downtrend consolidation).

C. Complex Divergence

Complex divergence compares two momentum indicators with different lookback periods, reflecting different time cycles (e.g., 7-period vs. 14-period).

• Complex Bullish Signal:
  • The longer-period indicator continues lower to new lows.
  • The shorter-period indicator bottoms and starts to rise towards zero.
  • Indicates two cycles are out of sync, suggesting a bullish reversal (occurs at the end of a downtrend).
• Complex Bearish Signal:
  • The longer-period indicator continues to rally to new highs.
  • The shorter-period indicator reaches a peak and starts to drop toward zero.
  • Indicates two cycles are out of sync, suggesting a bearish reversal (occurs at the end of an uptrend).

Factors Affecting Divergence Strength

The significance of a divergence signal is increased by:

• Number of Divergences: The more divergences, the greater the significance.
• Time Span: A greater time span between divergences indicates greater significance.
• Period Length: Divergences in a longer-period oscillator are more important than those in a shorter-period oscillator.
• Closeness to Equilibrium: The closer the oscillator is to its equilibrium level (e.g., the zero line or 50% line) at the time of the divergence, the larger the expected subsequent price move.

Divergence Traps

A "divergence trap" occurs when, just as a price drop is expected following a divergence, a final, often unexpected, rally develops. This rally pushes the momentum indicator higher (sometimes due to short covering), but the price then falls as previously expected once the short covering ends.

Summary of Divergence Types

Divergences act as an early warning of possible price reversal, not actual buy or sell signals.

• Classic Divergence: Price makes a new high/low, but the oscillator does not.
• Hidden Divergence: Oscillator makes a new high/low, but the price does not (suggests trend continuation).
• Complex Divergence: The longer-period oscillator makes a new high/low, but the shorter-period oscillator does not (while moving towards equilibrium).

Recommendation: Look for bearish divergences in an uptrend and bullish divergences in a downtrend. Divergences generally do not work well during range-bound markets.