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Trader's Corner

Technical Indicators: 'Oscillators' (Part 2)

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Indicators are derived from, or are the results of, the computations of various formulas computed from either price or volume. That's all technical analysis works with in stocks; two inputs, price and volume.

The price used could be the High, Low, Open or Close. Most indicators, and the ones I will be describing briefly here, work with the closing price. A moving average formula is a simple example of a technical indicator. Take the last 10 closes of the Dow, add them, divide by 10 and you have a 10-day moving average; it 'moves' because with each day's close the close 11 days ago is dropped and today's close is added in; so, the average changes or 'moves' to a new result each day.

Oscillators are indicators that move with the (price) trend up or down and measures price 'momentum' in various ways. Oscillators are best known for their use in measuring potential extremes in a trend, especially in a strong up or down trend. These extremes are defined as 'overbought' or 'oversold'. A common use of this information is to look for shorting or put buying opportunities in a rising trend and buying opportunities in a falling trend.

Another important use of these type technical indicators is when there is a failure of an oscillator to also move, along with prices, to a new high or new low relative to the recent past.

Two very common oscillators are 'normalized' so that they only can have numbers ranging from 0 to 100. The Relative Strength Index (RSI) and Stochastic indicators move ('oscillate') between 0 and 100 only. This is unlike other technical indicators that measure momentum, such as the Moving Average Convergence Divergence model or 'MACD' (pronounced 'macdee') where the daily results can range from a positive to negative number.

Very frequently you will see below charts displayed by the various commentators on Option Investor.com and elsewhere, one or more of the 3 most common oscillators shown in the chart below. The Stochastics model in widest use is the 'Slow' variation, which employs a 'smoothing' factor that slows down the rate of fluctuation (oscillations) between the highs and lows.

By the way, you'll also note on the S&P 500 (SPX) daily chart below how recent lows held in the area of the dominant up trendline. The price pattern here was of most significance than the Indicators shown in suggesting a possible low and resumption of the up trendline (next key is if SPX pierces 1280).

The upper and lower (red or green) level lines on the 'normalized' (0 100) scale of the RSI and Slow Stochastics are the common 'default' settings for 'overbought' and 'oversold' settings typically seen on charting applications; 70,30 on the RSI and 80,20 on the Stochastic model. It's different on the MACD, where its use is more in seeing where the indicator stops falling and reverses to the upside and vice versa.

It matters a great deal which setting you select for 'length' on RSI and Stochastics. '5' is very short-term, 10 a bit less so, as well as 13 or 14 (a common setting). 10 would calculate its formula based on 10 daily closes on a daily chart, 10 hours on an hourly chart, 10 weeks on a weekly chart. On the RSI, I favor the use of 13 for daily charts, 21 for hourly and 8 for weekly charts (sometimes 13 for comparison on weekly charts).

I have gotten into the habit of using 21 as the 'length' setting for the daily Stochastics study, especially on the Dow 30 (INDU). There is no 'right' or 'wrong', 'good' or 'bad' setting on any of these. It depends a lot on how short, or longer, term you want to measure momentum for and whether you trade for small (price) swings or try to capture the longer intermediate trends (me).

NOTE: The Slow Stochastics indicator is often referred to simply as 'Stochastic(s)', since this variation of Stochastics is so common; the plural stochasticS is also common since there are two Stochastic lines that cross above and below each other.

For the MACD indicator when I use it, I use the common 12, 26 and 9 'default' settings suggested by Gerald Arpel, who invented MACD and use it like him, mostly on weekly charts.

A key reason why I use the Relative Strength Index (RSI) much more than the Stochastic and MACD indicators, which are in the same CLASS of Oscillator indicators, is for the instances when bullish or bearish PRICE/RSI DIVERGENCES show up by using the RSI specifically, which can signal trend reversals ahead.

I might as well diverge (no pun intended!) here and talk about my current market view, which includes one recent minor bullish price/RSI bullish divergences seen in the Nasdaq 100 hourly chart when using the 21-period RSI.

I noted last week how the Dow 30 (INDU) had reversed right at a well defined up daily chart trendline. A 'well-defined' trendline is my way of describing a trendline where the lows or highs establish AT LEAST 3 points for the straight trendline but usually I am seeing many more than 3 in this reference.

Looking now at the HOURLY chart below for INDU, we see the breakout above a well-defined down trendline with the move above 10900 (this down trendline is an 'internal' or 'best-fit' line drawn through the MOST number of highs).

Piercing the down trendline was followed by a further sharp INDU advance and a new high for the move. I've often seen that rallies led by the Dow (a 'solitary walk of the Dow'), to be defensive rallies that may imply only limited upside potential in the broader market. The rebound WAS splendid for a play in Dow Index (DJX) calls. The tip off buy occurred on the formation of the trendline lows around 10750.

Regarding my topic of the use of oscillators, the hourly RSI shown above never got 'fully' oversold at recent lows, so was of less use than trendline considerations. This relates to an aziom about PRICE patterns being the dominant or 'lead' consideration in technical analysis.

Indicators tend to 'confirm' or amplify what we're seeing in the price chart. Or, indicator extremes can put us on ALERT or HIGH ALERT for the potential for an upside or downside reversal. It is like saying: 'pay attention' here!

Looking at the hourly chart of the broader S&P 500 (SPX) shown below, SPX does look poised for a bullish trendline breakout above 1280 (although it still has some way to go to achieve a decisive upside penetration of its prior high). Tomorrow (Thurs) should tell the story on that. With SPX, the formation of the recent 1258 low and point 3 of a lower trend channel line, was the telling trendline consideration.

The RSI did not provide as much of an 'aid' as the price pattern in taking a bullish trading stance at recent lows in SPX, as seen above. '21' as my length setting (calculates 21 hourly closes) on the hourly chart is a 'fibonacci' number (e.g., 5, 8, 13, 21, etc.); and, which I have found highlights the short-term extremes quite well when using the hourly RSI indicator.

We don't always see the upper or lower extremes of 70/30 with the longer 21-hour setting, as noted at the up/down blue arrows above. When the extremes DO occur with this (length) setting, it often occurs at or near a trend reversal. I would also note ('as above, so below') that the prior high (and a good put trade) was not accompanied by an 'overbought' RSI reading; nor was an oversold extreme then seen on the recent low. Patterns repeat!

In the widely traded S&P 100 (OEX) index, an earlier, also well-defined, hourly down trendline was pierced on the move above 577 as shown on my next chart. A prior rally high around 583 is the next resistance point.

As the OEX is getting near 'overbought' territory it would put me on alert to not overstay in OEX calls if the prior high is not exceeded; or only briefly, after which the Index then falls back.

The tech heavy Nasdaq is of course lagging the NYSE market. Per my topic of oscillators, the Nasdaq 100 or NDX had a bullish price/RSI DIVERGENCE seen in the hourly chart and the (21-hour) RSI indicator. As hourly prices were falling to two successively lower lows, the RSI was trending higher. An opposite directional tilt in the price and RSI trendlines is highlighted below.

The price/RSI bullish divergence shown above was a good indication that an upside reversal was coming in NDX, but says nothing about how high this current rally can or will carry.

NDX is approaching resistance defined by the down trendline highlighted (red down arrow) above; and, resistance implied by the top end of the downside price gap at 1685. The 1680-1685 area will be the key test for how much further upside and buying interest, exists in the Nas 100 index.

I always try to emphasize that 'overbought' and 'oversold' relate a POTENTIAL vulnerability (to a reversal) only. A stock or an Index can stay oversold or overbought for a relatively long period in a strongly trending market. It is also true that rapid and steep advances or declines are not sustainable for an unlimited period. A market WILL correct at some point after a steep rise or fall, but WHEN is an open question.

This point is important because there is a tendency to think that the first time or two that an oscillator reaches an extreme reading, whether using an hourly, daily or a longer-term weekly chart, it might be time to EXIT that stock or Index.

However, we see many instances where the trend takes prices significantly higher or lower before there is a correction. Moreover, a 'correction' may turn out to be a SIDEWAYS move ONLY or a lateral consolidation. And, which has been going on for weeks, broadly speaking, in the current market.

Oscillators 'work' well in terms of timing and buying dips in a downswing and selling rallies in an upswing in a market that is experiencing two-sided price swings, rather than trending strongly in one direction.

The "stochastics process" (its first name) study was popularized by George Lane and someone who was involved in futures markets.

If I select Stochastics as a 'Study', in some applications such as Q-charts, I can edit length 'smoothing' of %K and 'smoothing' of something called '%D'. When these kind of choices are presented, I suggest setting the smoothing factor of %K to '1' so there is NO smoothing of this number. And I leave the default setting for smoothing of '%D' at 3; this is the number that 'smoothes out %K and that is the way this Indicator was designed to be used.

The most common 'length' used or the period (number of hours, days or weeks) that the stochastics formula will 'reference' tends to be either 9 or 14. At least these are common 'default' setting for 'length'; i.e., the number of closes that are calculated.

The stochastics 'default' oversold and overbought levels are typically pegged at 20 and at 80 and I find these a generally good setting, at least for the stock indexes. The stochastics can have very wide-ranging fluctuations between 0 and 100; e.g., a low at 5 or 10, a high at 90, especially in individual stocks and especially in ones more volatile in their price swings.

The Slow Stochastics indicator is composed of two lines a slower line called the percent D (%D) line which is simply a simple moving average of the faster %K line. As with the MACD, the two lines of varying speeds lead to 'crossovers' that generate buy and sell 'signals', at least that's how they're often perceived.

The Stochastic study looks at the current price in relation to the HIGHEST HIGH and LOWEST LOW in the period being measured. Stochastics plots the current close in relation to the price range over the length set for this indicator and gives this a percentage value.

Buy and sell crossover signals are considered to be optimal if they occur in or near the overbought and oversold zones, respectively. There will be instances of crossovers that occur in the middle of these ranges and these shouldn't be utilized unless there is compelling other technical considerations that are guiding you; for example, a break out above or below an important trendline.

I won't say more than this on Stochastics; too boring! There are some reasons why I tend to favor the use of similar Relative Strength Indicator or RSI indicator, which is a single ratio between an average of up closes versus the average of down closes for a given ('length') period. I'll get into this next Wednesday.

This Wed. Trader's Corner article serves as an adjunct to my weekend 'Index Trader' column. In my Trader's Corner article I update a midweek technical picture of the major indexes and use recent chart/technical indicator patterns to more fully explain their possible relevance to trading decisions in general.

More on my specific predictions, support and resistance, etc. is found in my weekend Index Trader column, available on the Option Investor.com WEB site (and not part of the e-mailed weekend OI Daily). You will see a web LINK to the Index Trader at the top of your weekend Option Investor Daily e-mail. My most recent (Sat, 2/11) Index Trader can also be viewed online by clicking here.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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