Oscillators

Oscillators are among the most valuable tools available to technical analysts, but they are also among the most misunderstood and misused. The trend of a market is the general direction of its price fluctuations-up, down, or sideways. A market's momentum is its rate of acceleration or deceleration. An oscillator is a mathematically derived measure of a market's momentum. As early as the 1920's, technical analysts were creating oscillators to measure a market's momentum rather than limiting their efforts to determining the market's trend.

In any trend, prices are gaining, maintaining, or losing momentum. A loss of momentum in an uptrend or a downtrend-prices rising or falling at a diminishing rate is an early warning sign that the trend might change soon. Therefore, when an oscillator shows that an uptrend is losing momentum, it is a cautionary signal that the uptrend may stall with prices either trading sideways or reversing into a downtrend. Similarly, when an oscillator indicates a loss of momentum in a downtrend, it may foreshadow a potential end to the downtrend.

Relative Strength Index

The relative strength index (RSI) was introduced by J. Welles Wilder, Jr. Of all the momentum oscillators currently in wide use, RSI responds the best to basic technical analysis methods such as trend lines, chart patterns, and support and resistance. Applying these methods to RSI in conjunction with overbought/oversold levels and divergences can provide very valuable insight into market behavior. RSI compares the relative strength of price gains on days that close above the previous day's close to price losses on days that close below the previous day's close.

The RSI can be constructed for any number of days that the technical analyst considers useful. Wilder's original suggestion was 14 days, but many analysts today will use a faster, more sensitive indicator, such as a 5, 7 or 9 day RSI. Overbought and oversold levels are usually drawn at 70 and 30 or at 80 and 20. The most reliable RSI buy and sell signals usually occur after RSI fails to confirm a new low or a new high in prices. Bullish divergence between a lower bottom in prices an a higher bottom in RSI sets up a potential buying opportunity, and bearish divergence between a higher top in prices and a lower top in RSI sets up a potential selling opportunity. When a trader identifies a bullish or bearish RSI divergence, he should then focus his attention on the price action of the market itself and wait for prices to confirm the RSI signal.

Figure 13 below of the March '00 US Dollar Index shows a 14 day RSI that is indicating extreme divergence on this latest move into new contract highs. A sell signal would be generated when the RSI turns down with a stop above the contract high.