The mass psychology is usually reflected in different patterns on the price charts. Some of these patterns can be further enhanced by the use of technical indicators known as oscillators. Not all oscillators are created equal. They are not only like trading systems that detect different entry and exit signals, but also they are primarily succumbed to the subjectivity of the individual trader. This is where the weakness of oscillators really comes into play. As with different market conditions, there is a myriad of different oscillators, each giving somewhat different overbought/oversold signals.

Oscillators can be used to analyze overbought/oversold conditions, divergences and crossovers that use multiple moving averages. Oscillators become most useful when its value approaches a high reading near its upper limits. This is usually interpreted as displaying an overbought condition. Prices are considered oversold when the oscillator approaches extreme lower levels.

The most simplistic use of crossovers involves two different moving averages that are comprised of a slow moving average and a fast moving average. When the fast average crosses above the slower moving average then a buy signal is generated. Conversely, when the faster moving average crosses below the slower moving average, then a sell signal is generated. The more volatile a market is, the greater the probability of getting a more reliable reading from the oscillator. The use of oscillators can tip us off as to an early warning that momentum is decaying within a particular price structure.

One such oscillator, the Ultimate Oscillator, co-developed by Chalek and Larry Williams in the early 1980's does a fine job of depicting divergences when applied against prices. You may obtain more detailed information on this in The Definitive Guide to Futures Trading Volume II by Larry Williams. It tends to signal that a trend is close to completion. Divergences occur when the oscillator and the price action diverge amongst themselves. For example, when the oscillator is making lower highs while the prices are making higher highs, then we have a potential set-up for loss of market momentum. Figure A. is a price chart of the June 2000 Nasdaq 100 futures chart. Note that when the market peak out in March of that year, the oscillator gave a clear warning as to the loss of momentum. Later in the autumn of that same year, the oscillator gave a buy signal as prices were making lower lows. So when would there be a good point of entry for each of these signals?

Looking at the same chart, a trader would first confirm the price divergence with the oscillator. The price bar that did the confirming would have a target sell stop set just below the low of that bar. A stop loss would be placed immediately at the high of that bar. If per chance that a higher price is made and you still have a divergence with the oscillator, then the process would be repeated. On the right side of the chart, a buy stop signal would be generated just above the high of the lowest bar made at the point of divergence. The stop loss would be set at the low of that bar. And again, if prices do make lower lows while the oscillator diverges, then the buying process would be repeated again for a new entry point. Rarely have we seen the process go beyond 3 attempts.

Try to overlay other technical price patterns that would avoid pitfalls of entering early into the trade. For example the same price chart that gave a sell signal in the spring of 2000, was accompanied by a very reliable price pattern known as a 5 point broadening wave reversal. These types of patterns almost always come on the heels of oscillator divergences. Point 1 would consist of a pivot high, followed by point 2 making a pivot low. Point 3 would be another pivot high that is higher than point 1. Point 4 would be another pivot low that is lower than point 2. And finally point 5 would be another pivot high that is higher than point 3. The pattern is completed with those 5 points. You would apply the same type of price structure when looking for buy signals, but in reverse. Point 1 would consist of a pivot low, followed by point 2 making a pivot high. Point 3 would be another pivot low that is lower than point 1. Point 4 would be another pivot high that is higher than point 2. And finally point 5 would be another pivot low that is lower than point 3. Believe it or not this price pattern sold for $1500 by a well-known vendor and author in the late 1970's. But ironically it is discussed in the Edwards and Magee book on Technical Analysis of Stock Trends. Therefore, always look for some sort of confirmation to further reduce the possibility of false oscillator interpretations.

Figure A

Conclusion:

Bottom line here:

Most oscillators are nothing more than momentum indicators.

As with most oscillators, they tend to be most useful when prices are in a trading range rather than in a trend. This makes it easier to determine overbought/oversold conditions. When prices trend, oscillators tend to generate many false signals. That is where divergences come into play along with other price pattern techniques.