Forex Fundamentals: Using Oscillators in Your Trading

The term “oscillators” describes histograms that swing in a repetitive fashion between two states or points. These high and low states typically indicate overbought and oversold market conditions, allowing traders to use trendline movements to determine when to enter and exit a trade and what position to take.

In forex trading, the most popular oscillators are momentum indicators. Because changes in momentum are directly correlated to changes in price, traders also use momentum indicators to gauge trend strength and determine the likelihood of a divergence.

Banded vs. Centered Oscillators

Banded oscillators typically have a designated upper and lower graphic range. This allows traders to easily identify overbought and oversold conditions as the trendline moves between two “banded” extremes. The lower band of range-bound indicators typically extends from 0 to 20 or 30 (depending on the oscillator), and the upper band spans from 70 or 80 to 100. Trendline movements that touch or breach the upper band are considered overbought, producing a bearish (sell) signal, while trendline readings that fall within the lower band are considered oversold, or bullish (buy) signals. With the exception of the RSI, banded oscillators are often lagging indicators, meaning that trendline movements follow changes in price rather than precede them. The stochastic oscillator is an example of a lagging, banded indicator.

In contrast, centered oscillators have no upper and lower bounds. Instead, trendline fluctuations are read in relation to a central point. Although their unbounded nature makes them less ideal for identifying overbought and oversold levels, centered oscillators are more adept at identifying the prevailing strength and direction of the price trend. On a centered oscillator, readings above the centerline are considered bullish, and dips below the centerline are interpreted as bearish. Centered oscillators such as the MACD are typically used to confirm the current trend and anticipate reversals.

Popular Forex Oscillators

The most widely used oscillators in forex trading are the stochastic oscillator, RSI, and MACD. All three are momentum indicators that are charted on separate graphs adjacent to that of price action.

Stochastic Oscillator and RSI

Both the stochastic oscillator and RSI are banded, range-bound oscillators, but they use different formulas to calculate price momentum. The stochastic oscillator looks at current prices in relation to previous highs and lows, while the RSI looks solely at recent gains and losses. In addition, the stochastic oscillator uses a three-day simple moving average as a second signal line to help identify divergences.

As a general rule, the stochastic oscillator is better suited for use in volatile, or “choppy,” markets, and the RSI is ideal for trending markets. That said, both indicators can be used in tandem to serve as checks and balances in a comprehensive trading strategy.

Stochastic Oscillator

RSI

What to Look For

Because the stochastic oscillator and RSI are both banded indicators, be on the lookout for trendline movements that traverse the upper and lower bands. To decrease your vulnerability to false signals, always trade in the direction of the trend, and don’t act on trend-defying signals until a trend reversal can be confirmed by price movement (when price continues to make higher highs or lower lows in the reverse direction).

When using the stochastic oscillator, keep an eye out for divergences (when price reaches a higher high or lower low and that same extreme isn’t mimicked by the oscillator) that indicate that the price trend may be primed for a reversal. If a price reversal is indeed imminent, you’ll see confirmation in the form of crossing signal lines and trendline movements that break outside of the current overbought/oversold range and continue toward the graph’s median (50).

MACD

As a centered oscillator, the MACD is used to gauge trend strength, direction, and momentum. The MACD histogram is created by taking the difference between a slow (26-day) exponential moving average (EMA) and a fast (12-day) EMA. The position of the MACD line relative to the centerline indicates trend direction, and the distance away from the centerline represents momentum. An additional 9-day EMA is plotted onto the MACD to serve as a signal line.

What to Look For

When the MACD crosses below the signal line, it produces a sell signal. When it crosses above the signal line, it’s considered a buy signal.

In addition to trading crossovers, look for divergences between the MACD and the price action graph, as this can signal a price reversal. As with other oscillators, it’s important to confirm a trend reversal before acting so you don’t fall victim to false signals. When using the MACD in your trading strategy, you might also look for a dramatic rise that results when the two moving averages that make up the MACD drift farther apart. This precipitous rise suggests that the market is overbought, but this signal should be confirmed using a banded indicator for the most accurate overbought/oversold readings.

Combining Oscillators With Other Tools

Because even the most accurate reporting tools can produce false signals, it’s important to have a means of confirming and comparing price trends across different analytical models. Using a trend indicator such as Bollinger Bands can help you determine the volatility of a currency pair and confirm a price trend before acting on a buy or sell signal produced by your oscillator. If you understand the trend direction, strength, and volatility level, you’ll be able to identify what signals are worth acting on.