The oscillator is only a secondary indicator in the sense that it must be subordinated to basic trend analysis. As we go through the various types of oscillators used by technicians, the impor­tance of trading in the direction of the overriding market trend will be constantly stressed. The reader should also be aware that there are times when oscillators are more useful than at others. For example, near the beginning of important moves, oscillator analysis isn't that helpful and can even be misleading. Toward the end of market moves, however, oscillators become extremely valuable. We'll address these points as we go along. Finally, no study of market extremes would be complete without a discussion of Contrary Opinion. We'll talk about the role of the contrarian philosophy and how it can be incorporated into market analysis and trading.
Interpretation of Oscillators
While there are many different ways to construct momentum oscillators, the actual interpretation differs very little from one technique to another. Most oscillators look very much alike. They are plotted along the bottom of the price chart and resemble a flat horizontal band. The oscillator band is basically flat while prices
may be trading up, down, or sideways. However, the peaks and troughs in the oscillator coincide with the peaks and troughs on the price chart. Some oscillators have a midpoint value that divides the horizontal range into two halves, an upper and a lower. Depending on the formula used, this midpoint line is usu­ally a zero line. Some oscillators also have upper and lower bound­aries ranging from 0 to 100.
General Rules for Interpretation
As a general rule, when the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may have gone too far too fast and is due for a correction or consolidation of some type. As another general rule, the trader should be buying when the oscillator line is in the lower end of the band and selling in the upper end. The crossing of the midpoint line is often used to generate buy and sell signals. We'll see how these general rules are applied as we deal with the various types of oscillators.
The Three Most Important Uses for the Oscillator
There are three situations when the oscillator is most useful. You'll see that these three situations are common to most types of oscillators that are used.
1. The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its bound­aries. The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. This warns that the price trend is overextended and vulnerable.
2. A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.
3. The crossing of the zero (or midpoint) line can give impor‑tant trading signals in the direction of the price trend.