4.2 How Oscillators Tell You About Possible Reversals

 
In the last chapter we categorized leading indicators as ‘oscillators’
 
An oscillator is a technical analysis gizmo that is banded between two extreme values that indicate short-term overbought or oversold conditions. Depending on market conditions, it moves between one extreme to the other, that is, it ‘oscillates’.
 
If you remember, leading indicators give us a signal of trend change before it happens, hence ‘leading’. Examples of leading Indicators are Stochastic, Relative Strength Index and the Parabolic SAR
 
Now you caught us here. On one hand we wish to discuss about the this categorization of leading and lagging indicators and on the other hand, in order to do that, we need to mention some of those by names. Question is whether to do that after we talk about those specific indicators or before? Difficult situation! Well, let's talk about this categorization first without worrying about the names of the indicators. You are gonna learn about those soon.
 
Well, now that the little grey cells are refreshed, let’s take a look at how useful these oscillators are, and why, sometimes, you’ll be yelling and shouting rude things at them!
 
The stochastic and RSI have the ability to signal whether the market is overbought or oversold. During trading, in an uptrend, if either of these starts to turn down after reaching an overbought zone, be prepared for a reversal of the trend or a significant correction. Similarly, in a downtrend, if these oscillators reach the oversold zone and started to turn up, look for a reversal of trend or correction. The parabolic SAR, of course, has nothing to do with overbought or oversold zones, and will simply place a dot below or above the price line when the trend reverses.
 
Now let’s see how they work with the help of an example.
 
 
Example of leading indicator on a Forex chart. 
 
 
Look at the price and oscillator action at the green arrow. The stochastic and RSI are oversold but the Parabolic SAR has not flipped to show a trend change. Since all the three guys are not in agreement, you may not like to jump in heads on and may like to check for other signs like divergences, candlestick patterns, trend-lines and any fixed resistance and support zones etc. Some of these you have already learned about and some will catch up with you soon. etc. 
 
Now let’s see what happened around the blue arrow. Both the stochastic and RSI are coming out of the oversold region, Well, so far so good. But this time the Parabolic is also in lock step and flips to the other side. In the price line we see the formation of reversal candles such bullish engulfing. Things are nicely aligned for an up move; we go long and rake it in!
 
If you are getting carried away, and thinking this is the guru mantra for retiring to the beach, here’s a dunk in cold water – these leading guys sometimes go wrong. 
 
Watch what happened at the red arrow. Everything went hunky-dory with all three oscillators shouting out a reversal, you went long, then leaned back with $$$ in your eyes! Another example of oscillators going wrong can be seen in the following Forex chart with RSI and Stochastic oscillator:
 
False signals by leading indicators.
 
Bump! The trade backfired and your stop was hit just a few candles out.
 

Moral of the story. You may like check on various other tools as mentioned above and in the next chapters. But above all remember that no indicator can go right all the time. In trading you will have winning hands as well as losing hands. Manage the risks properly.

 

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