Oscillators are used to:

• Calculate the momentum or rate of change of currency prices.
• Identify overbought and oversold markets
• Show the direction and strength of trends.

Note:

Most oscillators are used as secondary indicators. Once the general direction of a trend has been established, oscillators help time the placement of trades.

Since an oscillator is not primarily a trend-following indicator, it may signal a market shift in advance of any price action, tempting traders to initiate trades against the general trend.

Going against a trend can be a costly and painful exercise . Oscillators are no substitute for basic trend analysis. Just because a market appears overbought or oversold does not mean that it will actually change direction.

Momentum = latest closing price - closing price 10 days ago.

The momentum oscillator was one of the first oscillators used by market analysts. A 10-day momentum oscillator takes the closing price of a currency from ten days ago and subtracts it from the most recent closing price. The resulting number is plotted above or below a zeroline.

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If prices are rising and the oscillator is above the zeroline and rising, an uptrend is accelerating.

If the upward sloping oscillator line begins to flatten, the new gains being achieved by the latest closes are the same as the gains made ten days earlier. While prices may still be rising, the rate of ascent (the momentum) has leveled off.

When the oscillator line begins to drop toward the zeroline, the uptrend is still in force, but at a decelerating rate, showing that the uptrend is losing momentum.

If prices are falling and the oscillator line moves below the zeroline, the latest 10-day close is now under the close of ten days ago and a near-term downtrend is in effect.

As momentum continues to drop farther below the zeroline, the downtrend gains momentum.

When the line begins to advance again the downtrend is decelerating.

• Momentum oscillators generate numerous false buy and sell signals.

• They have no fixed boundaries (such as 0 to 100), making it difficult to use them to measure overbought and oversold conditions.

The RSI calculates an ongoing comparison of a currency''s gains and losses against its own price history.

It incorporates exponential moving averages in its construction, weighing the index toward the most recent price data.

• If you are trading on a very short-term basis and want the oscillator swings to be more pronounced, the time period can be shortened.

• A 9- or 7-period length is popular with short-term traders.

• Intermediate and long-term traders might want to use a length between 60 and 90.

• Movements of the 9-period RSI are wider, so the 80 and 20 levels are sometimes used in place of the 70 and 30.

• Wilder’s RSI works best when the index''s fluctuations reach the upper and lower extremes.

Oversold levels of the RSI showed good buying areas within the dollar-yen uptrend.

Bearish Divergence in the weekly British pound chart warned of an impending trend reversal.

Prices are rising, but the oscillator is falling.

• Prices make a high with the RSI above 70.

• Prices retrace, and then make a higher high.

• At the same time the RSI makes a lower high.

This pattern, called a “negative” or “bearish” divergence warns of a possible reversal of an uptrend.

This pattern warns of a near-term bottom and a possible reversal of the downtrend.

Test Your Knowledge of Bullish Divergence

Looking at the chart below, describe three events that occurred to signal a positive divergence.

• An important requirement for making a trading decision based on divergence is that it takes place near the oscillator extremes.

• There is never a rush to sell against an uptrend or buy into a downtrend.

• In an uptrend, an RSI moving into overbought territory is only meaningful if it subsequently makes a lower high while actual prices rise to new highs.

• The time to pay close attention is if the second move by the oscillator fails to make new highs.

Some traders prefer the Stochastic to the RSI because the crossover more precisely pinpoints overbought or oversold levels.

Developed by George Lane, the Stochastic measures the price of a currency against its recent trading range.

It is based on the premise that

1) Prices close near the upper end of a trading range in an Uptrend, and

2) Prices close near the bottom end of a trading range in a Downtrend.

The two lines that make up the Stochastic fluctuate between 0 and 100.

A crossover of the faster "%K" line above the slower "%D" line when the Stochastic is below 20 indicates oversold conditions and the prospect of a price rally or sideways market. When the %K line crosses below the %D line with the oscillator above 80, the market has reached overbought levels, indicating that a price decline or sideways market may develop.

Note:

Interestingly, George Lane made a similar comment about Divergence and the Stochastic as did Welles Wilder about the RSI; Lane said that the only valid signal derived from the %D line is when there is a divergence between it and price.

The MACD Oscillator shows when a trend is gaining or losing momentum.

The MACD is the difference between the 12-and 26-period EMA lines.

As a trend-following indicator, the MACD can be interpreted similarly to other moving averages.

• When the MACD Line crosses above the MACD Signal Line, an uptrend may be beginning.

• Conversely, when the MACD Line crosses below the MACD Signal Line, a downtrend may be beginning.

• Used as an oscillator, the MACD can signal overbought and oversold conditions.

No single technical indicator can be relied upon by itself to consistently predict price trends, reversals, or corrections. That being said, the MACD is one of the better technical tools in the currency market.