Oscillators are one class of technical analysis indicators that are very popular and gauge the momentum of an asset’s price, indicating oversold and overbought conditions in a market.
Oversold conditions refer to a situation where a downward move has been exhausted and selling volume is starting to diminish. Overbought conditions refer to a market where the buyers are running out of steam and buying volume is decreasing.
Oscillators are just one part of a trader's toolkit and can be combined with other form of analyses. There are several oscillators that can be used as part of your technical analysis, with some of the most popular being the Average Directional Index, the MACD, the Relative Strength Index and the Stochastic.
Average Directional Index
Created by J. Welles Wilder and originally designed to be used for commodities on the daily chart, the Average Directional Index (ADX) quantifies the strength of a trend. The ADX is measured between 0 and 100 and a higher number indicates a stronger trend, where:
- A reading below 20 suggests that no trend is in play,
- A reading above 25 indicates a trend is in play,
Many traders also use the value of 30 to indicate a breakout after a ranging market and to reduce the occurrences of false signals above 25. For instance, quantitative strategist Paul Rabbitt was quoted in How The Pros Use Average Directional Index and mentioned that he used the Index as a momentum strategy:
“If it is above 30, I consider it a stronger momentum situation. Even if ADX changes direction, as long as it remains above 30, I regard it as a momentum situation. And the higher the level, the greater the strength of the momentum.”
The ADX is built on two indicators, the Plus Directional Indicator (+DI) and the Minus Direction Indicator (-DI), where:
- Plus Directional Indicator (+DI) = current high - previous high (if negative, +DI = 0)
- Minus Directional Indicator (-DI) = prior low - current low (If negative, -DI = 0).
The ADX is then constructed by taking the smoothed average of the difference between +DI and -DI.
The ADX cannot say anything about whether the trend is bullish or bearish. Instead, the Index used to identify whether the market is ranging or about to start a new trend. For instance, if BTC-PERP is not trending and the ADX is below 30, we can look for a breakout and for the ADX to move above 30 to get in on a trend.
The chart below shows an example.
Notice that the ADX went above 30 as the bitcoin price hovered near $9,500, but the rise of the ADX preceded a large downward move. The index eventually reached a value of 55 as the price tested lows near $8,100:
The ADX eventually settled below 30, which tells us the downward trend became worn out. Notice that the ADX dips below 30 as the price rested near $8,300.
In the example above, the ADX does not tell you whether to go long or short when the index starts to move above 30 but instead says that the current trend is strengthening. You could combine the ADX with other indicators to take a direction. Also, the ADX may also be useful for recognising when to exit a trade, for instance, if the ADX falls below 30 and you’ve initiated a trend following strategy, then it may be best to close the position and cut your losses.
The Moving Average Convergence Divergence (MACD) is another oscillator which displays the relationship for two moving averages of an asset’s price, which was created by Gerald Appel in the 1960s.
By default, the MACD is calculated by taking the difference between the 13-period exponential moving average (EMA) and the 26-period exponential moving average:
MACD = 13-period EMA - 26-period EMA
Since the MACD tracks the difference between moving averages, it can be used to identify a trend. The two lines displayed by the MACD indicator represent the moving averages of the difference between the two exponential moving averages. The MACD is often displayed with a histogram as well which plots the difference between the slower and faster moving average.
The main strategy used with the MACD is a crossover, when the faster moving average crosses above or below the slower moving average. When the faster line crosses over the slower one, the fast EMA diverges and signals that a new trend has formed. As a trend forms, we should look for large bars in the histogram which generally indicate that the trend is strong.
The chart below illustrates how to use the MACD to trade cryptocurrencies like bitcoin.
On August 20, there was an upward crossover of the MACD suggesting that an upward trend is likely to form. At the time of the crossover, the price of bitcoin was at $9,576. After the crossover, the MACD started to trend up and the size of histogram bars increased as well suggesting momentum in the upward move was increasing.
The price of bitcoin eventually reached a high of $10,832 on September 3:
On September 5, a downward crossover of the MACD occurred which would have specified to exit the long position and/or to enter a short position. The price increased in the trading sessions that followed but eventually started to fall from $10,900 to $9,945.
The drawback of the MACD indicator is that divergences are not able to predict every reversal. Often, you may see a crossover in the MACD and take a position but it turns out to be a fake signal or false positive. Given MACD is a lagging indicator, it may take several signals before you catch a move with strong momentum.
Relative Strength Index
The Relative Strength Index (RSI) is another indicator created by J. Welles Wilder and introduced in his book New Concepts in Technical Trading Systems. The RSI is a way to gauge the strength of a trend.
The default period used for the RSI is 14, but you can change this depending on which timeframe is being analysed; a larger number for higher timeframes and a smaller number for lower timeframes. Fibonacci numbers are usually quite effective as the period calculations for oscillators.
The RSI ranges between 0 and 100 and indicates overbought conditions when the value of the index is above 70. Oversold conditions are indicated when the index drops below 30. Another useful signal given by the RSI is that if it crosses from below to above 50, this indicates a rising trend, whereas a move from above to below 50 indicates a falling trend.
As the chart below shows, the RSI indicates when the market is overbought or oversold:
The yellow circles show where the RSI was near 30 and near 70. Notice that around the time of the first dip in the RSI below 30, the price action bottomed around $7,750 and provided a good opportunity to buy bitcoin. The price of bitcoin then proceeded higher until reaching $8,300 where the RSI breached 70, giving an opportunity to sell.
However, these are just benchmark figures and the RSI readings depend a lot on the market you are trading and whether the prevailing trend is up or down. For instance, in a strong uptrend, an oversold reading is likely to be higher than 30. Similarly, an overbought reading in a strong downtrend is likely to be lower than 70.
You can adjust the setting for oscillators depending on the timeframe you are analysing by going to settings then inputs. For instance, you will want to use lower number of periods for lower timeframe setups, and higher number of periods for higher timeframe setups:
The weakness of the RSI is that if an asset is in a very strong trend, then the RSI may remain in overbought or oversold conditions for very long periods of time. Instead, you should use an indicator that will confirm the trend (such as moving averages or the Williams’ Alligator) and then use the RSI to sell when over overbought in downtrends or buys when oversold in an uptrend.
The Stochastic is an oscillator similar to the RSI which was developed in the 1950s by George Lane. This oscillator can help traders determine when a trend may be coming to an end by measuring the momentum of price. The Stochastic is calculated using the closing price of an asset and its price range over a certain period of time.
The Stochastic indicates overbought and oversold conditions and is measured between 0 to 100. The market is considered to be overbought when the stochastic is above 80 (perhaps motivating a short position). Market conditions are suggested to be oversold when the indicator is below 20 (perhaps motivating a long position).
An example is shown below for BTC-USD. Notice that the Stochastic pushed below 20 on two occasions suggesting the market was oversold as bitcoin traded near $9,200 and would have suggested entering a long position.
Shortly afterwards, the price of bitcoin entered an upward trend and rose as high as $12,000. As the price of bitcoin traded near $12,000, the Stochastic moved above 80 indicating overbought conditions. Here, a short position would have been profitable. With an entry around $12,000 in the beginning of August, the position would would been profitable by mid-August when the price dipped below $10,000.
As with the RSI, the price of an asset can remain oversold or overbought for a long period of time so you should not go short or long just because the Stochastic goes above 80 or below 20. Instead, you should use an indicator that will confirm the trend (such as moving averages or the Williams’ Alligator) and then use the Stochastic to sell when an asset is overbought in downtrends (or buy when oversold in an uptrend).