Oscillating Indicators
Oscillating indicators are, usually, leading indicators that are most useful in analyzing securities or equities that are currently range-bound. Range-bound securities are securities that are trading in a price range; in other words, they are not in an identifiable trend but are trading sideways in a range. In essence, oscillators are also range-bound, as they are designed to fluctuate between a fixed maximum value, usually 100, and a fixed minimum value, usually -100, with a center-line at 0,. As a result, oscillators are not as useful in trending markets as they will often generate false signals when the price action is trending in one direction for an extended period of time. Under these conditions, the purpose of the oscillator is to identify possible turning points in the price action, which is why they are most useful in a range-bound market.
These turning points are identified when the oscillator reaches extreme upper and lower levels, which indicate overbought and oversold conditions, respectively. An overbought condition occurs when the oscillator reaches a level that is considered to be too high, which indicates that the price action may have been too optimistic and that a potential reversal to the downside may be imminent. Conversely, an oversold condition occurs when the oscillator reaches a level that is considered to be too low, which indicates that the price action has been too pessimistic and that a potential reversal to the upside may be imminent. Oscillators move higher and lower between overbought or oversold conditions and indicate potential turning points for a security as overbought and oversold conditions would, respectively, equate with find unsustainable levels of optimism and pessimism for the underlying security.
While overbought and oversold conditions also exist in trending markets; these conditions can persist for an extended period of time, which makes oscillating indicators less reliable in strong trending conditions. In addition, oscillators tend to be leading indicators, which is also the reason why they are not as useful in a trending market, as they turn before the price does.
There are several oscillating indicators that can be used to analyze non-trending securities with the Stochastic Oscillator being one of the most popular. Other oscillators include Relative Strength Index (RSI), Rate of Change (RoC), Williams %R, and others. Each oscillator has a set of reference points that will generate entry and exit signals when the price action deviates too much from its normal range.
Oscillator Period
Shortening the period for an oscillator is generally preferred over increasing it. A shorter period oscillator will be more sensitive to price changes and will signal turning points earlier as the price action develops on the chart. Also, as oscillators are said to be leading indicators, they often change direction before the price reverses its trend, a phenomena referred to as divergence. As a result, oscillators should not be used immediately when they turn to generate entry signals, especially when the underlying security is still in a seemingly strong trend.
Reference Lines
Most oscillators have set reference lines to indicate the overbought and oversold areas. However, for some unbound oscillators you need to determine the upper and lower extremes over a relatively long period and draw the reference lines so that the oscillator only spends about 5% of the time beyond the reference lines. These reference lines should be adjusted on a regular basis. Some traders draw their own reference lines for oscillators that have predefined reference lines, such as the 30 and 70 lines of the RSI.