Oscillators can be a very useful indicators in trading if used correctly. However misusing them will only return disappointing results.
Some of the most popular examples of oscillators are the stochastics, and . I will use in this tutorial, but the same logic applies to most other oscillators.
What are oscillators:
Oscillators are indicators that derive their value from the price . The price is an input for the oscillator formula. The formula is usually a simple calculation that compares the latest close value for the price to a the range of price over a specific period of time( u can change this period in the oscillators settings). Then give the result in a percentage format(0 to 100). The main purpose of this calculation is to show whether the price is overbought or oversold compared to that period range. For example: if reading is at 80% or above, its said to be overbought. And if at 20% below it is oversold.
When the price is making new highs and the oscillator fails to make a new high, this is called a divergence. The opposite is true, when the price is making new lows and the oscillator fails to make new lows this is called a . is a buy signal and divergence is sell signal.
If you follow the overbought and oversold signals and divergences as a sell and buy signals without taking in consideration the price trend, the results will be catastrophic. ill explain why shortly
How to use oscillators to maximize your chances:
1) In TRENDING MARKETS
Rule #1: Oversold signals in uptrending market is a reliable buy signal.
Overbought signals in downtrending market is reliable sell signal.
Look at the chart, start from the left, you can see that the price broke above the latest swing high for the prior down trend, And that signalled a potential reversal. Accordingly, a trader should had looked to buy new oversold signals on . Afterwards, every time the . was oversold in this uptrending market, we witnessed a rebound and resumption of the uptrend.
Same logic should be applied to downtrending market.
Rule #2: Overbought doesn't mean sell if occurs in an uptrend, and oversold doesn't mean buy if in downtrend.
Rule #3 : divergence doesn't mean sell if occurs in an uptrend, and doesn't mean buy if occurs in a downtrend.
This might be counter intuitive, but the chart above gives a clear example:
As you can see on the chart, when the market is up-trending, overbought, and divergences signals are very common due to the fact that there is a strong demand. Therefore these signals are NOT RELIABLE and should be ignored. UNLESSthere are other major multiple technical indications of reversal such as a major , and a formation, or trend structure break. Same logic goes for down-trending market, where you should ignore oversold signals and divergences.
At the end of the chart, another example of a breakout below the uptrend structure. That was an early signal of a new downtrend. After that breakout, traders should look to sell new OB signals on .
2) In SIDEWAYS MARKETS
Overbought and oversold are reliable on a sideways market. Have a look at the image below
If you spot a side-ways market, look to buy oversold signals and sell overbought signals. As the price tends to reverse direction near the top and bottom of the range. If the range is broken, you should exit your trade and stop applying the the logic of sideways market. instead look to apply the logic of the trending market explained above.
Hope this will help you trade better