In this chapter, we've discussed the use of the oscillator in market analysis to help determine near term overbought and oversold conditions, and to alert traders to possible divergences. We start­ed with the momentum line. We discussed another way to mea­sure rates of change (ROC) by using price ratios instead of differ­ences. We then showed how two moving averages could be com­pared to spot short term extremes and crossovers. Finally, we looked at RSI and Stochastics and considered how oscillators should be synchronized with cycles.
Divergence analysis provides us with the oscillator's greatest value. However, the reader is cautioned against placing too much importance on divergence analysis to the point where basic trend analysis is either ignored or overlooked. Most oscillator buy signals work best in uptrends and oscillator sell signals are most profitable in downtrends. The place to start your market analysis is always by determining the general trend of the market. If the trend is up, then a buying strategy is called for. Oscillators can then be used to help time market entry. Buy when the market is oversold in an uptrend. Sell short when the market is overbought in a downtrend. Or, buy when the momentum oscillator crosses back above the zero line when the major trend is bullish and sell a crossing under the zero line in a bear market.
The importance of trading in the direction of the major trend cannot be overstated. The danger in placing too much impor­tance on oscillators by themselves is the temptation to use diver­gence as an excuse to initiate trades contrary to the general trend. This action generally proves a costly and painful exercise. The oscil­lator, as useful as it is, is just one tool among many others and must always be used as an aid, not a substitute, for basic trend analysis.