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TECHNICAL ANALYSIS

USING OSCILLATORS AS  TREND FOLLOWING INDICATORS

In technical analysis, there are 2 main types of indicators: trend indicators – also defined as “lagging” indicators - and oscillators – also defined as “leading” indicators.

In the first category we find for example moving averages or MACD. These can be very useful when prices register strong oscillations, forming strong trends. However they don’t give us any indication about the starting point of a trend. They simply identify it in an attempt to follow its full development. 

This first type of indicator generates buying or selling signals only when a trend has already started to develop, and can be considered as “late” because they don’t spot the beginning of the move. This said, generally they also generate safer trading decisions, precisely because they follow an existing underlying market direction. This is why trend indicators give better results with strong price movements.

In the second category of leading indicators, we can find for example oscillators such as RSI and Stochastic. The way they work is that they try to identify overbought and oversold situations in order to anticipate the trend inversion, or the beginning of a new price direction. In that case, the indicator will give better results during a trading range, as buy and sell signals will generate trading decisions, which are linked to the anticipation of market moves.

That’s why it is fundamental to understand in which kind of market we’re operating. During strong trend periods, it will be preferable to use lagging indicators, whereas, during a trading range, it will be wiser to use leading indicators. Most of the time, using leading indicators during strong trend periods, or vice versa, using oscillators during a trading range, will generate more loss than profit.

Using the crossing point between the price and the moving average as a buy or sell signal during a trading range, could give false signals which would generate a series of stop losses. In the same way, oscillators used during strong market movements will often read overbought and oversold conditions as trend inversions, which won’t be confirmed and therefore will generate large losses, if positions aren’t protected by the right stop loss.

Becoming familiar with one or other of these categories of indicators is a matter of personal choice. Many traders use both kinds successfully. But, in any case, it is important to recognize which market phase we are in. A mystic skill is then to be able to predict the following market phase or trend.

In this article we would like to introduce a different methodology, which is to use oscillators as trend indicators. This technique combinethe best qualities of both types of indicator.

We’ve chosen to use one of the most famous technical analysis oscillators: the Stochastic indicator. (But the same principle can be used, with the necessary adjustments, for all kinds of oscillators).

The Stochastic gives precise indications regarding overbought and oversold levels. On a 1-to-100 scale, the indicator identifies 2 zones: when the indicator reaches the level of 80, we are in an overbought situation and therefore prices are then expected to go down. On the contrary, when the indicator reaches 20, we are in an oversold phase and prices are then expected to go up.  

In a trading range, such signals will be very useful to read price movements, whereas they won’t be of use in a period of strong bullish or bearish trend.

To use the Stochastic indicator profitably in a trend phase, it is necessary to check when the K% line is above 80 and remains above this level. Then it is possible to anticipate the beginning of a strong bullish trend. And this trend will be confirmed as long as the K% line doesn’t return back under the 80 level. The same technique can be implemented in the reverse situation, when the K% line is and remains below 20 and anticipates a bearish move.

This methodology allows us to distinguish between the various market phases: when the indicator will move in-between 20 and 80, it will mean that the market is in a trading range. And when these levels will be broken on a stable basis, the indicator will identify a bullish trend above 80 and a bearish trend below 20.

It will then be difficult – if not impossible - to forecast a new market direction if, for example, the 80 level gets broken. With a bit of experience, being able to recognize when the trend is in a potential inversion state, will be very useful.   

Here are a few examples of the implementation of this technique.

On chart n.1 the K% blue line, reaches values below 20 on 30 July 2008.  See how the indicator remains oversold (with values below 20) for 44 days in a row, and then returns back above 20 on 13 September.   After a bullish correction, the K% line returns back to an oversold condition, and from October 3 stays in this condition until October 30.  During the first bearish move, the Stochastic succeeded in following the trend for 1,770 pips. In the second bearish trend, the oscillator confirmed the move for 854 pips.

technical analysis oscillators

It is important to note that the bullish correction which links these 2 phases, reaches its maximum level precisely when the Stochastic reaches 80 (overbought). As explained before, this is exactly what can help anticipating the beginning of a bearish trend.  

In this example showing the USD-JPY hourly chart (chart n.2), the K% line remains in an overbought situation for 41 consecutive hours, confirming a bullish move of 215 pips.

technical analysis oscillators

Here is another example (chart n.3) of 2 bullish trends where the K% line remains in an overbought condition for 41 hours and then 24 hours. The correction phase between these 2 bullish trends is very short and the oscillator doesn’t succeed in canceling the overbought conditions. As soon as the K% line returns above 80, the trend gains new momentum during 180 Pips.

technical analysis oscillators

On daily timescales, this technique works particularly well between 13 and 18, whereas with short timescales values between 30 and 38 give very good results, and the value 34, which is also one of the Fibonacci sequential numbers, seems to work very well with many currency crosses.

This methodology, like all trading techniques, can be modified to be adapted to each trader’s style and preferences.

To conclude, let’s emphasize the fact that combining the interpretation of a market trend with the use of an oscillator can be very useful. Using the Stochastic indicator: when the K% line fluctuates between 20 and 80 the indicator confirms a trading range and it is possible to Sell at 80 and Buy at 20. When, on the contrary, the overbought and oversold levels (80 and 20) are broken on a stable basis, the oscillator helps identifying the new market phase, and we should change strategy: Buy above 80 and Sell below 20.

Rodolfo Festa Bianchet
CEO and Founder
Trade Interceptor