An
oscillator is any object or data that moves back and forth between two points.
In other
words, it's an item that is going to always fall somewhere between point A and
point B. Think of when you hit the oscillating switch on your electric fan.
Think of
our technical indicators as either being "on" or "off".
More specifically, an oscillator will usually signal "buy" or
"sell", with the only exception being instances when the oscillator
is not clearly at either end of the buy/sell range.
Does this
sound familiar? It should!
The
Stochastic, Parabolic SAR, and Relative Strength Index (RSI) are all
oscillators. Each of these indicators is designed to signal a possible
reversal, where the previous trend has run its course and the price is ready to
change direction.
Let's
take a look at a couple of examples.
We've
slapped on all three oscillators on GBP/USD's daily chart shown below. Remember
when we discussed how to work the Stochastic, Parabolic SAR, and RSI?
If you
don't, we're sending you back to fifth grade!
Anyway,
as you can see on the chart, all three indicators gave buy signals towards the
end of December. Taking that trade would've yielded around 400 pips in gains.
Ka-ching!
Then,
during the third week of January, the Stochastic, Parabolic SAR, and RSI all
gave sell signals. And, judging from that long 3-month drop afterwards, you
would've made a whole lot of pips if you took that short trade.
Around
mid-April, all three oscillators gave another sell signal, after which the
price made another sharp dive.
Now let's
take a look at the same leading oscillators messing up, just so you know these
signals aren't perfect.
In the
chart below, you can see that the indicators could give conflicting signals.
For
instance, the Parabolic SAR gave a sell signal in mid-February while the
Stochastic showed the exact opposite signal. Which one should you follow?
Well, the
RSI seems to be just as undecided as you are since it didn't give any buy or
sell signals at that time.
Looking
at the chart above, you can quickly see that there were a lot of false signals
popping up.
During
the second week of April, both the Stochastic and the RSI gave sell signals
while the Parabolic SAR didn't give one. The price kept climbing from there and
you could've lost a bunch of pips if you entered a short trade right away.
You
would've had another loss around the middle of May if you acted on those buy
signals from the Stochastic and RSI and simply ignored the sell signal from the
Parabolic SAR.
What happened to such a good set of indicators?
The
answer lies in the method of calculation for each one.
Stochastic
is based on the high-to-low range of the time period (in this case, it's
hourly), yet doesn't account for changes from one hour to the next.
The
Relative Strength Index (RSI) uses the change from one closing price to the
next.
Parabolic
SAR has its own unique calculations that can further cause conflict.
That's
the nature of oscillators. They assume that a particular price movement always
results in the same reversal. Of course, that's hogwash.
While
being aware of why a leading indicator may be wrong, there's no way to avoid
them.
If you're
getting mixed signals, you're better off doing nothing than taking a "best
guess". If a chart doesn't meet all your criteria, don't force the trade!
Move on
to the next one that does meet your criteria.
