Oscillators are a type of technical indicator. They can be used to determine potential market reversals and to analyze the market trend strength. These indicators go back and forth (or “oscillate”) between two closed values to identify when the asset is in an overbought or oversold price territory.
Oscillators are a broad group of indicators with many falling into this category. We will focus on the three that are used most frequently. These are RSI (Relative Strength Index), Stochastic RSI and MACD (Moving Average Convergence Divergence).
Oscillators are selectable on most interactive trading charts, such as Bitstamp’s Tradeview.
OSCILLATORS ESSENTIALS
- Oscillators are widely-used and easy-to-learn technical indicators.
- Oscillators are used to identify a market’s strength or weakness and to determine whether an asset is overbought or oversold.
- Three widely-used oscillators are: RSI (Relative Strength Index), Stochastic RSI and MACD.
- Divergences between price and oscillator movement are utilized to identify whether the market is bullish or bearish.
RSI – Relative Strength Index
RSI is used to measure how much the price is changing in the direction of its movement, be it up or down. The indicator oscillates between values 0 and 100.
The asset is considered to be overbought when RSI is above 70. This means there was significant upward price movement without correction, which implies buyers are losing momentum.
The asset is considered to be oversold when RSI is below 30. A vast price decline with no correction means that the sellers are getting exhausted.
When RSI enters overbought or oversold levels it signifies a potential market reversal and can thus provide a trader with good buy or sell points. One must note that, in a strong bull or bear trend, it frequently happens that RSI enters and stays in these extreme levels for quite some time. This usually happens because market participants are subject to irrational decision-making, usually manifesting as FOMO.
Divergences
Trendlines are a great tool to analyze RSI, as they can be drawn on the RSI chart. This allows us to observe divergences between the price and RSI movements. Divergences can either signify bearishness or bullishness and can be divided into three categories: regular, hidden and exaggerated divergences.
(1A) a regular bearish divergence is when the price reaches a higher high, while RSI achieves a lower high.
(1B) a regular bullish divergence is when the price hits a lower low and RSI achieves a higher low.
(2A) a hidden bearish divergence is when the price reaches a lower high, while RSI achieves a higher high.
(2B) a hidden bullish divergence is when the price hits a higher low and RSI achieves a lower low.
(3A) an exaggerated bearish divergence is when the price forms a double top, while RSI hits a lower high.
(3B) an exaggerated bullish divergence is when the price forms a double bottom and RSI reaches a higher high.
Recognizing different divergences is very useful for identifying market strength (or weakness) and thus spotting potential buy or sell points that the price alone is not reflecting.
Stochastic RSI
Stochastic RSI is an oscillator which is mainly used to spot market trend reversals. It also oscillates between the values 0 and 100. Its overbought levels are above 80, while its oversold levels are below 20. Crossing these levels usually indicates a high possibility of an incoming trend reversal, or at least a price correction.
However, in a strong bull or bear market trend, the Stochastic RSI can irrationally surpass these levels and remain above or below them for an extended period of time. Therefore, it is not wise to rely on it as a standalone indicator. Traders can also mitigate the risk of these situations by not succumbing to emotional decision-making, which can be achieved by following two rules: (1) execute a buy order when the oscillator leaves an oversold zone (goes above 20), and (2) execute a sell order when the oscillator leaves an overbought zone (goes below 80).
Divergences also form on Stochastic RSI but far less often than on the regular RSI. This is because Stochastic RSI is rather extreme and thus reaches its overbought and oversold zones frequently.
MACD – Moving Average Convergence Divergence
MACD is an indicator that consists of two exponential moving averages (26-period EMA and 12-period EMA) and a histogram.
The rules of potential signals from this indicator’s exponential moving averages are the same as for regular moving averages. When the faster moving average crosses above the slower one, it indicates bullishness (a buy signal) and when the faster moving average crosses below the slower one, it indicates bearishness (a sell signal).
The histogram, which is drawn in the form of vertical columns, represents the space between the moving averages. When the faster moving average is above the slower one, the histogram prints its columns above the zero value. When the faster moving average is below the slower one, it prints columns below zero value. The bigger the space between the moving averages, the bigger the columns of a histogram are.
The histogram reflects how strong the current trend is. When it is nearing zero value, it signals that the trend is weakening. Crossing the zero line can thus be a good buy or sell signal, although it is not recommended to use this as a standalone indicator.
MACD works best when analyzing divergences, which are the same as with RSI. Drawing trendlines on MACD’s moving average movements and asset price movements, combined with observing the histogram, is how traders can utilize the power of this oscillator to the maximum.
Oscillators are useful, as they are an invaluable tool for identifying the market’s condition. They are also easy to learn, which makes them one of the most popular indicators among cryptocurrency traders. To maximize their efficiency, it is best to combine them with other technical indicators and tools.