Oscillators And Reversal Indicators

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Oscillators and trend-following indicators are valuable tools that help traders to locate trading ideas and to find additional confirmation of what they're seeing in the charts. Technical indicators are broken down into two areas: trend-following tools and oscillators. Both will help you to identify trending markets, overbought and oversold conditions, pullbacks, and turning points. You'll find that certain indicators resonate with you, while others don't. The object of using them is to help you narrow down an idea, not for confirmation alone. Price action and volume are the only factual confirmations available to a trader. Indicators will help you locate the potential for price action.

Combining charting with indicators will provide you with additional objective confirmation of what you see. Charting is part art and part science. If your charts and indicators point toward the same conclusion, you will be able to trade with more conviction.

This will give you the impetus to stick to your game plan. The best way to get the most out of indicators is to find one or two that you like, and combine them with another indicator from a different area.

For example, the Relative Strength Index is a popular oscillator that is a leading indicator. It measures overbought and oversold conditions by tracking the changes in a stock's closing price. Bollinger bands are statistical tools that use a 21-day moving average and two standard deviations to produce overbought and oversold signals. You can increase your conviction by combining these two separate measurement sources to see if they confirm one another.

Oscillators are powerful tools for confirming a pullback during a trend. It is during the period of time when trends consolidate that oscillators produce potent signals for reentry onto the trend. Going long during a pullback within an uptrend is referred to as trading the up hook. The up hook is a second chance to enter a move that you might have missed earlier. If a stock is in an uptrend and the oscillator pulls back beneath its lower oversold line and then crosses above it, you have a potential signal to trade the trend from the long side. During a downtrend, if the oscillator pops up above the overbought line and then crosses beneath it, you have a potential signal to trade from the short side.

Many traders mistakenly believe that oscillators work best when stocks are caught within a trading range. They may go short with an overbought signal or go long with an oversold signal, and hope to hang on until the stock reaches the other side of the range. This technique is simply bottom or top fishing a range because it looks like prices are either low or high. This sort of trading mentality should be avoided. A trader's objective should be to buy or sell stocks that are moving in your direction, not against you.

Oscillators can be used to produce overbought and oversold signals within a range; but the danger is that sooner or later the range will be broken, and you'll be caught on the wrong side of the trade. Oscillators produce overbought and oversold signals when prices are in a trend and pull back within that trend.

Oscillators also produce potent overbought and oversold signals when they diverge from price action. Some of the strongest reversal patterns oscillators produce are with divergence signals. When prices continue to move toward new highs or new lows, and the oscillator indicators do not confirm that price action, you have price divergence.

Illustration 17-1 presents diagrams of the different types of divergence that occur between prices and the indicators.54"

Be careful not to get overwhelmed by using multiple indicators. The simpler your trading rules the better. Trading is not meant to be a complicated endeavor. The best traders are successful because they have a high degree of confidence in their particular trading plans. If a trader is constantly looking at various indicators and jumping from one to the next, then it will be difficult to develop the conviction and belief necessary to win.

If you get overwhelmed by indicators, you'll increase the odds for procrastination, indecision, and overall analysis paralysis. Remember that trading is a game of action, not thought. Too much tinkering and thinking inhibits a trader. Soon after you enter into a position, you'll know whether you're right or wrong. Distractions are a trader's enemy and should be avoided at all costs. Select only a few simple indicators that you understand and believe in.

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